BY :VAIBHAV MALHOTRA

EMAIL:vaibhav4u38@rediffmail.com

CH APTER ON E

FIN AN CIAL M AN AGEM EN T : AN OVERVI EW

Que s t io n : What d o yo u me an b y fi nancia l manag e me nt ?

Ans we r :
M e aning o f Financ ial M anag e me nt :
The pri mary task of a C harte re d Accoun tan t i s to de al w i th
funds, 'Man age me nt of Funds ' i s an i mportan t aspe ct of fi nanci al
mana ge me nt i n a busi ne ss unde rtaki n g or any othe r i nsti tuti on l i ke
hospi tal , art soci e ty, and so on. The te rm 'Fi nanci al Manage me nt' has
be e n de fi ne d di ff e re ntl y by di ff e re nt authors.
Accordi n g to Sol omon "Fi nanci al Manage me nt i s conce rne d
w i th the e ffi ci e nt use of an i mporta nt e conomi c re sou rce , name l y
capi tal funds. " Phi l l i ppatus has gi ve n a more el aborate de fi ni ti on of
the te rm, as , "Fi nanci al Manage me nt, i s conce rne d wi th the mana ge ri al
de ci si ons that re sul ts i n the acqui si ti on and fi nanci ng of short and
l ong te rm cre di ts for the fi rm. " Thus, i t de al s w i th the si tuati ons that
re qui re se le cti on of spe ci fi c pro bl e m of si ze and grow t h of an
e nte rpri se . The anal ysi s of the se de ci si ons i s base d on the expe cte d
i nfl ow s and outfl ow s of funds and the i r eff e ct on manage ri al obj e cti ve s.
The most acce ptabl e de fi ni ti on of fi nanci al manage me n t i s that gi ve n
by S. C .Kuchhal as, "Fi nanci al mana ge me nt de al s wi th procu re me nt of
funds and thei r e ff e cti ve uti li sati on i n the busi ne ss. " Thus, the re are 2
basi c aspe cts of fi nanci al manage me nt :

1 ) p ro cure me nt o f f unds :
As funds can be obtai ne d from di ff e re nt source s thus, the i r
proc ure me n t i s al w ays consi de re d as a compl ex probl e m by busi ne ss
conce rns. The se funds proc ure d from di ff e re nt source s have di ff e re nt
characte ri sti cs i n te rms of ri sk, cost and control that a manage r must
consi de r w hi l e proc uri n g funds. The funds shoul d be procu re d at
mi ni mum cost, at a bal ance d ri sk and control factors.
Funds rai se d by i ssue of e qui ty share s are the be st from ri sk
poi nt of vi ew for the compan y, as i t has no re payme n t li abi l i ty exce pt
on wi ndi ng up of the compan y, but fro m cost poi nt of vie w , i t i s most
expe nsi ve , as di vi de nd expe ctati ons of share hol de rs are hi ghe r than
pre vai l i ng i nte re st rate s and di vi de nds are appropri ati o n of profi ts and
not al l owe d as expe nse unde r the i ncome tax act. The i ssue of ne w
e qui ty share s may di l ute the control of the exi sti ng share hol de rs.
De be nture s are compar ati ve l y che ape r si nce the i nte re st i s
pai d out of profi ts be fore tax. B ut, the y e ntai l a hi gh de gre e of ri sk
si nce the y have to be re pai d as pe r the te rms of agre e me nt; al so, the
i nte re st payme nt has to be made w he the r or not the company make s
profi ts.
Funds can al so be procu re d from banks and fi nanci al
i nsti tuti ons, the y pro vi de funds subj e ct to ce rtai n re stri cti ve cove nants.
The se cove nants re stri ct fre e dom of the borrow e r to rai se loans from
othe r source s. The re form proce ss i s al so movi ng i n di re cti on of a
cl ose r moni tori ng of 'e nd use ' of re sou rce s mobi l i se d throu gh capi tal
marke ts. Such re stri cti ons are e sse nti al for the safe ty of funds provi de d
by i nsti tuti ons and i nve stors. The re are othe r fi nanci al i nstrume nts
use d for rai si ng fi nance e. g. comme rci al pape r, dee p di scount bonds,
e tc. The fi nance manage r has to bal ance the avai l abi l i ty of funds and
the re stri cti ve provi si on s tie d wi th such funds re sul ti ng i n l ack of
fl exi bi l i ty.
I n the gl obal i se d compe ti ti ve sce nari o, i t i s not e nough to
de pe nd on avai l abl e w ays of fi nance but re source mobi l i sati on is to be
unde rta ke n throu gh i nnovati ve w ays or fi nanci al prod ucts that may
me e t the nee ds of i nve stors. Mul ti pl e opti on conve rti bl e bonds can be
si ghte d as an exampl e , funds can be rai se d i ndi ge nousl y as al so from
abroad. Fore i gn Di re ct I nve stme nt (F DI ) and Fore i gn I nsti tuti onal
I nve stors (FI I ) are tw o maj or source s of fi nance fro m abroa d al ong wi th
Ame ri can De posi tory Re ce i pts (ADR's) and Gl obal De posi tory Re ce i pts
(GDR's). The me chani sm of proc uri ng funds i s to be modi fi e d i n the
l i ght of re qui re me nts of fore i gn i nve stors. Procu re me nt of funds i nte r
al i a i ncl ude s :

- I de nti fi cati on of source s of fi nance

- De te rmi nati o n of fi nance mi x
- Rai si n g of funds
- Di vi si on of profi ts be twe e n di vi de nds and re te nti on of profi ts i .e .
i nte rnal fund ge ne rati on.

2 ) e ff e ct ive us e o f s uch f unds :

The fi nance mana ge r is al so re sponsi bl e for e ff e cti ve uti l i sati on of
funds. He must poi nt out si tuati ons w he re funds are ke pt i dl e or are
use d i mprope rl y. Al l funds are procu re d at a ce rtai n cost and afte r
e ntai l i ng a ce rtai n amount of ri sk. If the funds are not uti l i se d i n the
manne r so that the y ge ne rate an i ncome hi ghe r than cost of
proc ure me n t, the re i s no me ani ng i n runni ng the busi ne ss. It i s an
i mporta nt consi de rati on i n di vi de nd de ci si ons al so, thus, i t i s cruci al to
e mpl oy funds prope rl y and profi t abl y. The funds are to be e mpl oye d i n
the manne r so that the company can prod uce at i ts opti mum l e ve l
w i thout e ndange ri ng i ts fi nanci al sol ve ncy. Thus, fi nanci al i mpl i cati ons
of e ach de ci si on to i nve st i n fi xe d asse ts are to be pro pe rl y anal yse d.
For thi s, the fi nance mana ge r must posse ss sound know l e dge of
te chni que s of capi tal bud ge ti ng and must ke e p i n vie w the nee d of
ade quate w orki ng capi tal and e nsure that w hi l e fi rms e nj oy an opti mum
l e ve l of w orki ng capi tal the y do not kee p too much funds bl ocke d i n
i nve ntori e s, book de bts, cash, e tc.
Fi xe d asse ts are to fi nance d from me di um or l ong te rm funds, and
not short te rm funds, as fi xe d asse ts cannot be sol d i n short te rm i. e .
w i thi n a ye ar, al so a l arge amount of funds w oul d be bl ocke d i n stock i n
hand as the company cannot i mme di ate l y se l l i ts fi ni she d goods.
Que s t io n : Ex p lain t he s cop e o f fi nanci al manag e me nt ?

Ans we r : Scop e of fi nancia l manag e me nt :

A soun d fi nanci al mana ge me nt i s esse nti al i n al l type of
fi nanci al organi sati o ns - w he the r profi t orie nte d or not, w he re funds are
i nvol ve d and al so i n a ce ntral l y pl anne d e conomy as al so i n a capi tal i st
se t-up. Fi rms, as pe r the comme rci al hi story, have not li qui date d
be cause the i r te chnol ogy w as obsol e te or the i r pro duc ts had no or l ow
de mand or due to any othe r factor, but due to l ack of fi nanci al
mana ge me nt. Eve n i n boom pe ri od, w he n a compa ny make s hi gh
profi ts, the re i s dan ge r of li qui dati o n, due to bad fi nanci al
mana ge me nt. The mai n cause of l i qui dati on of such compani e s i s ove r-
tradi n g or ove r-expandi ng w i thout an ade qua te fi nanci al base .
Fi nanci al manage me nt opti mi se s the output from the gi ve n i nput
of funds and atte mpts to use the funds i n a most prod ucti ve manne r. I n
a country li ke I ndi a, w he re re sou rce s are scarce and de mand on funds
are many, the ne e d for pro pe r fi nanci al manage me nt i s e normous. I f
pro pe r te chni que s are use d most of the e nte rpri se s can re duce the i r
capi tal e mpl oye d and i mprove re turn on i nve stme nt. Thus, as me n and
machi ne are pro pe rl y mana ge d, fi nance s are al so to be w el l manage d.
I n ne wl y starte d compani e s, i t i s i mportant to have sound
fi nanci al manage me nt, as i t e nsure s the i r survi val , ofte n such
compa ni e s i gnore s fi nanci al manage me nt at the i r ow n pe ri l . Eve n a
si mpl e act, l i ke de posi ti ng the che que s on the day of the i r re ce i pt i s
not pe rforme d. Such organi sati ons pay he avy i nte re st charge s on
borrow e d funds, but are tardy i n re al i si ng the i r ow n de btors. Thi s i s due
to the fact the y l ack re al i sati on of the conce pt of ti me val ue of mone y,
i t i s not app re ci ate d that each val ue of rupe e has to be made use of
and that i t has a di re ct cost of uti l i sati on. It must be re al i se d that
ke e pi ng rupe e i dl e eve n for a day, re sul ts i nto l osse s. A non- profi t
organi sa ti on may not be ke e n to make profi t, tradi ti on al l y, but i t doe s
ne e d to cut dow n i ts cost and use the funds at i ts di sposal to the i r
opti mu m capaci ty. A soun d se nse of fi nanci al manage me nt has to be
cul ti vate d among our bure aucr ats, admi ni strat ors, e ngi nee rs,
e ducati oni sts and publ i c at l arge . Unl e ss thi s i s done , col ossal w astage
of the capi tal re source s cannot be arre ste d.

Que s t io n : What are t he o b je ct ives o f fi nanci al manag e me nt ?

Ans we r :
Ob je ct ive s of fi nancial manag e me nt :
Effi cie nt fi nanci al mana ge me nt re qui re s exi ste nce of some
obj e cti ve s or goal s be cause j udgme nt as to w he the r or not a fi nanci al
de ci si on i s effi cie nt is to be made i n l i ght of some obj e cti ve . The tw o
mai n obj e cti ve s of fi nanci al manage me nt are :

1 ) Pro fi t M ax imis at io n :
I t i s tradi ti on al l y be i ng argue d, that the obj e cti ve of a company i s to
e arn profi t, he nce the obj e cti ve of fi nanci al mana ge me nt i s profi t
maxi mi sati on. Thus, e ach al te rnati ve , i s to be see n by the fi nance
mana ge r fro m the vie w poi nt of profi t maxi mi sati on. B ut, i t cannot be
the onl y obj e cti ve of a company, i t i s at be st a li mi te d obj e cti ve el se a
num be r of pro bl e ms w oul d ari se . Some of the m are :

a) The te rm profi t i s vague and doe s not cl ari fy w hat exactl y i t me ans.
I t conve ys di ff e re nt me ani ng to di ff e re nt pe opl e .

b) Profi t maxi mi sati on has to be atte mpte d w i th a re al i sati on of ri sks

i nvol ve d. The re i s di re ct re l ati on be tw ee n ri sk and profi t; hi ghe r the
ri sk, hi ghe r i s the profi t. For maxi mi si ng profi t, ri sk i s al toge the r
i gnore d, i mpl yi ng that fi nance manage r acce pts hi ghl y ri sky pro posal s
al so. Practi cal l y, ri sk i s a ve ry i mporta nt factor to be bal ance d wi th
profi t obj e cti ve .

c) Profi t maxi mi sati on i s an obj e cti ve not taki ng i nto account the ti me
patte rn of re turns.
E. g. Pro posal X gi ve s re turn s hi ghe r than that by propos al Y but, the
ti me pe ri od i s say, 10 ye ars and 7 ye ars re spe cti vel y. Thus, the ove ral l
profi t i s onl y consi de re d not the ti me pe ri od, nor the fl ow of profi t.

d) Profi t maxi mi sati on as an obj e cti ve i s too narrow , i t fai l s to take

i nto account the soci al consi de rati ons and obl i gati ons to vari ous
i nte re sts of w orke rs, consume rs, socie ty, as w el l as e thi cal trade
practi ce s. I gnori ng the se factors, a compa ny cannot survi ve for l ong.
Profi t maxi mi sati on at the c ost of soci al and moral obl i gati ons i s a
short si ghte d pol i cy.

2 ) We alt h max imis at io n :

The compani e s havi ng profi t maxi mi sati on as i ts obj e cti ve,
may adopt pol i ci e s yi e l di ng exorbi tan t profi ts i n the short run w hi ch are
unhe al thy for the grow th, survi val and ove ral l i nte re sts of the busi ne ss.
A compa ny may not unde rta ke pl anne d and pre scri be d shut- dow ns of
the pl ant for mai nte nance , and so on for maxi mi si ng profi ts i n the short
run. Thus, the obj e cti ve of a fi rm shoul d be to maxi mi se i ts val ue or
w e al th.
Accordi n g to Van Horne , "Val ue of a fi rm i s re pre se nte d by the
marke t pri ce of the compa ny's common stock. . .. . . . the marke t pri ce of a
fi rm's stock re p re se nts the focal j udgme nt of al l marke t parti ci pa nts as
to w hat the val ue of the parti cul ar fi rm i s. I t take s i nto account pre se nt
as al so pros pe cti ve futu re earni ngs pe r sha re , the ti mi ng and ri sk of
the se e arni ng, the di vi de nd pol i cy of the fi rm and many othe r factors
havi ng a be ari ng on the marke t pri ce of stock. The marke t pri ce se rve s
as a pe rforma nce i ndex or re port card of the fi rm's pro gre ss. I t
i ndi cate s how we ll manage me n t i s doi ng on be hal f of stockhol de rs. "
Sha re pri ce s i n the share marke t, at a gi ve n poi nt of ti me , are the
re sul t of a mi xture of many factors, as ge ne ral e conomi c outl ook,
parti cul ar outl ook of the compani e s unde r consi de rati on, te chni cal
factors and e ve n mass psychol ogy, but, take n on a l ong te rm basi s,
the y re fl e ct the val ue , w hi ch vari ous parti e s, put on the company.
N ormal l y thi s val ue i s a functi on, of :
- the l i ke l y rate of e arni ngs pe r share of the company; and
- the capi tal i sati on rate .

The l i ke l y rate of e arni ngs pe r share (EPS) de pe nds upon the

asse ssme nt as to the profi ta bl y a company i s goi ng to ope rate i n the
futu re or w hat i t i s l i kel y to earn agai nst e ach of i ts ordi nary share s.
The capi tal i sati on rate re fl e cts the li ki ng of the i nve stors of a
compa ny. I f a company e arns a hi gh rate of e arni ngs pe r share thro ug h
i ts ri sky ope rati ons or ri sky fi nanci n g patte rn, the i nve stors wi l l not
l ook upon i ts share wi th favour. To that exte nt, the marke t val ue of the
share s of such a company wi l l be l ow. An easy w ay to de te rmi ne the
capi tal i sati on rate i s to start wi th fi xe d de posi t i nte re st rate of banks,
i nve stor w oul d w ant a hi ghe r re turn i f he i nve sts i n share s, as the ri sk
i ncre ase s. How much hi ghe r re turn i s expe cte d, de pe nds on the ri sks
i nvol ve d i n the parti cul ar share w hi ch i n turn de pe nds on compa ny
pol i ci e s, past re cords, type of busi ne ss and confi de nce comman de d by
the mana ge me nt. Thus, capi tal i sati on rate i s the cumul ati ve re sul t of
the asse ssme nt of the vari ous share hol de rs re gardi n g the ri sk and
othe r qual i tati ve factors of a compan y. I f a compa ny i nve sts i ts funds i n
ri sky ve ntu re s, the i nve stors w i ll put i n the i r mone y i f the y ge t hi ghe r
re turn as compare d to that from a l ow ri sk share .
The marke t val ue of a share i s thus, a functi on of e arni ngs pe r
share and capi tal i sati on rate . Si nce the profi t maxi mi sati o n cri te ri a
cannot be appl i e d i n re al w orl d si tuati ons be cause of i ts te chni cal
l i mi tati on the fi nance manage r of a compa ny has to e nsure that hi s
de ci si ons are such that the marke t val ue of the share s of the compa ny
i s maxi mum i n the l ong run. Thi s i mpl i e s that the fi nanci al pol i cy has to
be suc h that i t opti mi se s the EPS, kee pi ng i n vi ew the ri sk and othe r
factors. Thus, w e al th maxi mi sati on i s a be tte r obj e cti ve for a
comme rci al unde rtaki n g as compare d to re turn and ri sk.
The re i s a grow i ng e mphasi s on soci al and othe r obl i gati ons of
an e nte rpri se . I t cannot be de ni e d that i n the case of unde rtaki ngs,
e spe ci all y those i n the publ i c se ctor, the que sti on of w e al th
maxi mi sati on i s to be see n i n context of soci al and othe r obl i gati ons of
the e nte rpri se .
I t must be unde rsto od that fi nanci al de ci si on maki ng i s re l ate d
to the obj e cti ve s of the busi ne ss. The fi nance mana ge r has to e nsure
that the re i s a posi ti ve i mpact of e ach fi nanci al de ci si on on the
furthe rance of the busi ne ss obj e cti ve s. O ne of the mai n obj e cti ve of an
unde rtaki n g may be to "prog re ssi ve l y bui l d up the capabi l i ty to
unde rta ke the de si gn and de ve l opme nt of ai rcraft e ngi ne s, he l i copte rs,
e tc. " A fi nance manage r i n such case s w i ll al l ocate funds i n a w ay that
thi s obje cti ve i s achi e ve d al thou gh such an al l ocati on may not
ne ce ssari l y maxi mi se we al th.

Que s t io n : What are t he f unct io ns of a Finance M anag e r ?

Ans we r :
Funct io ns o f a Finance M anag e r :
 The tw i n aspe cts, proc ure me nt and eff e cti ve uti l i sati on of
funds are cruci al tasks face d by a fi nance mana ge r. The fi nanci al
mana ge r i s re qui re d to l ook i nto the fi nanci al i mpl i cati ons of any
de ci si on i n the fi rm. Thus al l de ci si ons i nvol ve manage me n t of funds
unde r the purvi e w of the fi nance manage r. A l arge numbe r of de ci si ons
i nvol ve substan ti al or mate ri al change s i n val ue of fund s procu re d or
e mpl oye d. The fi nance mana ge r, has to manage funds i n such a w ay so
as to make the i r opti mum uti l i sati on and to e nsure the i r proc ure me nt i n
a w ay that the ri sk, cost and control are pro pe rl y bal ance d unde r a
gi ve n si tuati on. He may not, be conce rne d wi th the de ci si ons, that do
not aff e ct the basi c fi nanci al mana ge me nt and structure .
The natu re of job of an accounta nt and fi nance manage r i s
di ff e re nt, an accountan t's job i s pri mari l y to re cord the busi ne ss
transacti o ns, pre pare fi nanci al state me nts show i ng re sul ts of the
organi sa ti on for a gi ve n pe ri od and i ts fi nanci al condi ti on at a gi ve n
poi nt of ti me . He i s to re cord vari ous hap pe ni ngs i n mone tary te rms to
e nsure that asse ts, l i abi l i tie s, i ncome s and expe nse s are pro pe rl y
gro upe d, cl assi fi e d and di scl ose d i n the fi nanci al state me nts.
Accoun tan t i s not conce rne d w i th mana ge me nt of funds that i s a
spe ci al i se d task and i n mode rn ti me s a compl ex one . The fi nance
mana ge r or cont rol l e r has a task e nti re l y di ff e re nt from that of an
account ant, he i s to manage funds. Some of the i mportan t de ci si ons as
re gards fi nance are as fol l ow s :

1 ) Es t imat ing t he re q uire me nt s of f und s : A busi ne ss re qui re s

funds for l ong te rm purpose s i. e. i nve stme nt i n fi xe d asse ts and so on.
A care ful e sti mate of such funds i s re qui re d to be made . An
asse ssme nt has to be made re gardi n g re qui re me nts of w orki ng capi tal
i nvol vi ng, esti mati on of amount of funds bl ocke d i n curre nt asse ts and
that l i kel y to be ge ne rate d for short pe ri ods throu gh curre n t li abi l i ti e s.
Fore casti ng the re qui re me nts of fund s i s done by use of te chni que s of
bud ge tary control and l ong range pl anni ng. Esti mate s of re qui re me nts
of funds can be made onl y if al l the physi cal acti vi ti e s of the
organi sa ti on are fore caste d. The y can be transl ate d i nto mone tary
te rms.

2 ) De cis io n re g ard ing cap it al s t ruct ure : O nce the re qui re me n ts of

funds is e sti mate d, a de ci si on re gardi ng vari ous source s from w he re the
funds w oul d be rai se d is to be take n. A prope r mi x of the vari ous
source s i s to be w orke d out, e ach source of funds i nvol ve s di ff e re nt
i ssue s for consi de rati on. The fi nance manage r has to care ful l y l ook i nto
the exi sti ng capi tal structu re and se e how the vari ous pro posal s of
rai si ng funds w il l aff e ct i t. He i s to mai ntai n a pro pe r bal ance be tw ee n
l ong and short te rm funds and to e nsure that suffi ci e nt l ong- te rm fund s
are rai se d i n orde r to fi nance fi xe d asse ts and othe r l ong- te rm
i nve stme nts and to provi de for pe rmane nt ne e ds of w orki ng capi tal . I n
the ove ral l vol ume of l ong- te rm funds, he i s to mai ntai n a prope r
bal ance be twe e n ow n and l oan funds and to se e that the ove ral l
capi tal i sati on of the compa ny i s such, that the company is abl e to
proc ure funds at mi ni mum cost and i s abl e to tol e rate shocks of le an
pe ri ods. Al l the se de ci si ons are know n as 'fi nanci ng de ci si ons'.

3 ) Inve s t me nt de cis io n : Funds procu re d fro m di ff e re nt source s have

to be i nve ste d i n vari ous ki nds of asse ts. Long te rm funds are use d i n a
proj e ct for fi xe d and al so curre nt asse ts. The i nve stme nt of fund s i n a
proj e ct i s to be made afte r care ful asse ssme nt of vari ous proj e cts
thro ug h capi tal budge ti ng. A part of l ong te rm funds is al so to be ke pt
for fi nanci n g w orki ng capi tal re qui re me nts. Asse t mana ge me nt pol i cie s
are to be l ai d dow n re gardi ng vari ous i te ms of curre nt asse ts, i nve ntory
pol i cy i s to be de te rmi ne d by the produc ti on and fi nance manage r,
w hi le ke e pi ng i n mi nd the re qui re me n t of prod ucti on and future pri ce
e sti mate s of raw mate ri al s and avai l abi l i ty of fund s.

4 ) Divid e nd de cis io n : The fi nance manage r i s conce rne d w i th the

de ci si on to pay or de cl are di vi de nd. He i s to assi st the top manage me nt
i n de ci di ng as to w hat amount of di vi de nd shoul d be pai d to the
share hol de rs and w hat amount be re tai ne d by the compa ny, i t i nvol ve s
a l arge num be r of consi de rati ons. Economi cal l y spe aki ng, the amou nt
to be re tai ne d or be pai d to the share hol de rs shoul d de pe nd on w he the r
the compan y or share hol de rs can make a more profi ta bl e use of
re sou rce s, al so consi de rati ons l i ke tre nd of e arni ngs, the tre nd of share
marke t pri ce s, re qui re me nt of funds for future grow th, cash fl ow
si tuati on, tax posi ti on of sha re hol de rs, and so on to be ke pt i n mi nd.
The pri nci pal func ti on of a fi nance manage r re l ate s to
de ci si ons re gardi ng procure me nt, i nve stme nt and di vi de nds.

5 ) Sup p ly of f und s to all p art s o f t he o rg anis at io n o r cas h

manag e me nt : The fi nance manage r has to e nsure that al l se cti ons
i .e . branche s, factori e s, uni ts or de partme nts of the orga ni sati on are
suppl i e d w i th ade quate funds. Se cti ons havi ng exce ss funds contri bu te
to the ce ntral pool for use i n othe r se cti ons that nee ds funds. An
ade quate suppl y of cash at al l poi nts of ti me i s absol ute l y esse nti al for
the smooth fl ow of busi ne ss ope rati ons. Eve n i f one of the many
branche s i s short of funds, the w hole busi ne ss may be i n dange r, thus,
cash manage me nt and cash di sburse me nt pol i ci e s are i mportant wi th a
vi ew to suppl yi n g ade quate funds at all ti me s and poi nts i n an
organi sa ti on. I t shoul d e nsure that the re i s no exce ssi ve cash.

6 ) Evalu at ing fi nancia l pe rf o rmance : Manage me nt control syste ms

are usual l y base d on fi nanci al anal ysi s, e. g. RO I (re turn on i nve stme nt)
syste m of di vi si onal control . A fi nance manage r has to constan tl y
re vi e w the fi nanci al pe rformance of vari ous uni ts of the orga ni sati on.
Anal ysi s of the fi nanci al pe rformance he l ps the mana ge me nt for
asse ssi ng how the funds are uti l i se d i n vari ous di vi si ons and w hat can
be done to i mprove i t.

7 ) Financ ial neg o t iat io ns : Fi nance manage r' s maj or ti me i s uti l i se d

i n carryi ng out ne goti ati ons w i th fi nanci al i nsti tuti ons, banks and publ i c
de posi tors. He has to furni sh a l ot of i nformati o n to the se i nsti tuti ons
and pe rsons i n orde r to e nsure that rai si ng of funds is w i thi n the
statute s. Ne goti ati ons for outsi de fi nanci ng ofte n re qui re s spe ci al i se d
ski l l s.

8 ) Ke e p ing in t o uch wit h st o ck e x chang e q uo t at io ns and

b e havio r of share p rice s : I t i nvol ve s anal ysi s of maj or tre nds i n the
stock marke t and j udgi ng thei r i mpact on share pri ce s of the company 's
share s.
Que s t io n : What are t he vario us met ho ds and t oo ls us ed fo r
fi nanci al manag e me nt ?

Ans we r : Fi nance manage r use s vari ous tool s to di scharge hi s

functi ons as re gards fi nanci al manage me nt. I n the are a of fi nanci ng
the re are vari ous me thods to procu re funds from l ong as al so short
te rm source s. The fi nance manage r has to de ci de an opti mum capi tal
structu re that can contri bu te to the maxi mi sati o n of share hol de r's
w e al th. Fi nanci al l e ve rage or tradi ng on e qui ty i s an i mporta nt me thod
by w hi ch a fi nance manage r may i ncre ase the re turn to commo n
share hol de rs.
For e val uati on of capi tal pro posal s, the fi nance manage r
use s capi tal budge ti ng te chni que s as payb ack, i nte rnal rate of re turn,
ne t pre se nt val ue , profi ta bi l i ty i ndex, ave rage rate of re turn. I n the
are a of curre nt asse ts mana ge me nt, he use s me thods to che ck e ffi ci e nt
uti l i sati on of curre nt re source s at the e nte rpri se 's di sposal . An
e nte rpri se can i ncre ase i ts profi t abi l i ty wi thout aff e cti ng i ts li qui di ty by
an effi cie nt manage me nt of w orki ng capi tal . For i nstance , i n the are a of
w orki ng capi tal manage me n t, cash manage me nt may be ce ntral i se d or
de -ce ntral i se d; ce ntral i se d me thod i s consi de re d a be tte r tool of
mana gi ng the e nte rpri se 's l i qui d re source s. I n the are a of di vi de nd
de ci si ons, a fi rm i s face d w i th the pro bl e m of de cl arati on or postpo ni ng
de cl arati on of di vi de nd, a probl e m of i nte rnal fi nanci n g.
For e val uati on of an e nte rpri se 's pe rforma nce , the re are
vari ous me thods, as rati o anal ysi s. Thi s te chni que i s use d by al l
conce rne d pe rsons. Di ff e re nt rati os se rvi ng di ff e re nt obj e cti ve s. An
i nve stor use s vari ous rati os to e val uate the profi t abi l i ty of i nve stme nt
i n a parti cul ar compa ny. The y e nabl e the i nve stor, to j udge the
profi tabi l i ty, sol ve ncy, li qui di ty and grow t h aspe cts of the fi rm. A short-
te rm cre di tor i s more i nte re ste d i n the li qui di ty aspe ct of the fi rm, and
i t i s possi bl e by a study of l i qui di ty rati os - curre nt rati o, qui ck rati os,
e tc. The mai n conce rn of a fi nance manage r i s to provi de ade quate
funds from be st possi bl e source , at the ri ght ti me and at mi ni mum cost
and to e nsure that the funds so acqui re d are put to be st possi bl e use .
Funds fl ow and cash fl ow state me nts and proj e cte d fi nanci al state me nts
he l p a l ot i n thi s re gard.

Que s t io n : Dis cus s t he ro le of a fi nance manag e r ?

Ans we r : In the mode rn e nte rpri se , a fi nance manage r occupi e s a ke y

posi ti on, he bei ng one of the dynami c me mbe r of corporate manage ri al
te am. Hi s rol e , i s be comi ng more and more pe rvasi ve and si gni fi cant i n
sol vi ng compl ex mana ge ri al pro bl e ms. Tradi ti on al l y, the rol e of a
fi nance manage r w as confi ne d to rai si ng funds fro m a numbe r of
source s, but due to re ce nt de ve l opme nts i n the soci o - economi c and
pol i ti cal sce nari o thro ug hou t the w orl d, he i s pl ace d i n a ce ntral
posi ti on i n the organi sati o n. He i s re sponsi bl e for shapi ng the fortune s
of the e nte rpri se and is i nvol ve d i n the most vi tal de ci si on of al l ocati on
of capi tal li ke me rge rs, acqui si ti ons, etc. A fi nance mana ge r, as othe r
me mbe rs of the corporate te am cannot be ave rse to the fast
de ve l opme nts, aroun d hi m and has to take note of the change s i n orde r
to take re le vant ste ps i n vie w of the dynami c change s i n
ci rcums tance s. E. g. i ntrod ucti on of Euro - as a si ngl e curre nc y of
Euro pe is an i nte rnati onal le vel change , havi ng i mpact on the corporate
fi nanci al pl ans and pol i ci e s w orl d-w i de.
Dome sti c de ve l opme nts as e me rge nce of fi nanci al se rvi ce s
se ctors and SEB I as a w atch dog for i nve stor pro te cti on and re gul ati n g
body of capi tal marke ts is contri bu ti ng to the i mportance of the fi nanc e
mana ge r's j ob. B anks and fi nanci al i nsti tuti on s we re the maj or source s
of fi nance , mono pol y w as the state of aff ai rs of I ndi an busi ne ss,
share hol de rs sati sfacti on w as not the pro mote r's conce rn as most of
the compani e s, we re cl osel y he l d. Due to the ope ni ng of economy,
compe ti ti on i ncre ase d, se l le r's marke t i s bei ng conve rte d i nto buye r's
marke t. De ve l opme nt of i nte rne t has bro ug ht ne w chal l e nge s be fore the
mana ge rs. I ndi an conce rns no l onge r have to compe te onl y nati onal l y,
i t i s faci ng i nte rnati on al compe ti ti on. Thus a ne w e ra i s ushe re d duri ng
the re ce nt ye ars, i n fi nanci al manage me nt, spe ci al l y, w i th the
de ve l opme nt of fi nanci al tool s, te chni que s, i nstrume nts and prod ucts.
Al so due to i ncre asi ng e mphasi s on publ i c se ctor unde rtaki ngs to be
se l f-supp orti n g and the i r de pe nde nce on capi tal marke t for fund
re qui re me nts and the i ncre asi ng si gni fi cance of li be ral i sati on,
gl obal i sati on and de re gul ati on.

Que s t io n : Draw a t yp ical o rg anis at io n chart hig hlig ht ing t he

fi nance f unct io n of a co mp any ?

Ans we r : The fi nance functi on i s the same i n al l e nte rpri se s, de tai l s

may di ff e r, but maj or fe ature s are uni ve rsal i n nature . The fi nance
functi on occupi e s a si gni fi cant posi ti on i n an organi sa ti on and i s not
the re sponsi bi l i ty of a sole exe cuti ve . The i mporta nt aspe cts of fi nance
mana ge r are to carri e d on by top mana ge me nt i .e . managi n g di re ctor,
chai rma n, board of di re ctors. The board of di re ctors take s de ci si ons
i nvol vi ng fi nanci al consi de rati ons, the fi nanci al control l e r i s basi cal l y
me ant for assi sti ng the top manage me nt and has an i mportan t rol e of
contri bu ti ng to good de ci si on maki ng on i ssue s i nvol vi ng all functi onal
are as of busi ne ss. He i s to bri ng out fi nanci al i mpl i cati ons of all
de ci si ons and make the m unde rstood. He may be cal le d as the fi nanci al
control l e r, vi ce -pre si de nt (fi nance ), chi e f accounta nt, tre asure r, or by
any othe r de si gnati on, but has the pri mary re spon si bi l i ty of pe rformi ng
fi nance functi ons. He i s to di scharge the re sponsi bi l i ty kee pi ng i n vi ew
the ove ral l outl ook of the organi sa ti on.

BOARD OF DIRECTORS

PRESI DEN T
 V. P. (Produc ti on) V. P. (Fi nance ) V. P. (Sal e s)

Tre asu re r C ontrol l e r

C re di t C ash B anki ng Portfol i C orporate Taxe I nte rna B udge ti n

Mgmt. Mgmt. re l ati on o Mgmt. Ge ne ral & s l Audi t g
s C ost
Accounti n g

Org anis at io n chart of fi nance funct io n

The C hi e f fi nance exe cuti ve w orks di re ctl y unde r the Pre si de nt or

Managi ng Di re ctor of the company. Be si de s routi ne w ork, he kee ps the
B oard i nforme d about al l phase s of busi ne ss acti vi ty, i ncl usi ve of
e conomi c, soci al and pol i ti c al de ve l opme nts aff e cti ng the busi ne ss
be havi our and from ti me to ti me furni she s i nformati on about the
fi nanci al status of the compan y. Hi s functi ons are : (i ) Tre asur y
functi ons and (i i ) C ontrol functi ons.

Re lat io ns hip Be t we e n fi nanci al manag e me nt and ot he r are as of

manag e me nt : The re i s cl ose re l ati onshi p be twe e n the are as of
fi nanci al and othe r manage me nt li ke prod ucti on, sal e s, marke ti ng,
pe rsonne l , e tc. Al l acti vi ti e s di re ctl y or i ndi re ctl y i nvol ve acqui si ti on
and use of funds. De te rmi nati o n of prod ucti on, proc ure me nt and
marke ti ng strate gi e s are the i mportant pre rog ati ve s of the re spe cti ve
de partme nt he ads, but for i mpl e me nti ng, the i r de ci si ons funds are
re qui re d. Li ke , re pl ace me nt of fi xe d asse ts for i mpro vi ng pro duc ti on
capaci ty re qui re s funds. Si mi l arl y, the pu rchase and sal e s pro moti o n
pol i ci e s are l ai d dow n by the purch ase and marke ti ng di vi si ons
re spe cti ve l y, but agai n procu re me nt of raw mate ri al s, adve rti si ng and
othe r sal e s promo ti on re qui re funds. Same i s for, re crui tme nt and
pro moti on of staff by the pe rsonne l de partme n t w oul d re qui re funds for
payme nt of sal arie s, w age s and othe r be ne fi ts. It may, many ti me s, be
di ffi cul t to de marcate w he re one functi on e nds and othe r starts.
Al thou gh, fi nance functi o n has a si gni fi cant i mpact on the othe r
functi ons, i t ne e d not l i mi t or obstruct the ge ne ral functi ons of the
busi ne ss. A fi rm faci ng fi nanci al di ffi cul tie s, may gi ve w ei ghtage to
fi nanci al consi de rati ons and de vi se i ts ow n pro ducti o n and marke ti ng
strate gi e s to sui t the si tuati on. W hi l e a fi rm havi ng surpl us fi nance ,
w oul d have comparati ve l y l ow e r ri gi di ty as re gards the fi nanci al
consi de rati ons vi s- a-vi s othe r functi ons of the mana ge me nt.

Pe rvas ive N at ure o f Finance Funct io n : Fi nance is the l i fe bl ood of

of an organi sati o n, i t i s the common thre ad bi ndi ng al l organi sati on al
functi ons. Thi s i nte rface can be expl ai ne d as bel ow :

* Pro d uct io n - Finance : Prod ucti on functi on re qui re s a l arge

i nve stme nt. Produc ti ve use of re sou rce s e nsure s a cost advan tage for
the fi rm. O pti mum i nve stme nt i n i nve ntori e s i mprove s profi t margi ns.
Many parame te rs of prod ucti on have an i mpact on cost and can
possi bl y be control l e d throu gh i nte rnal manage me nt, thus e nhanci ng
profi ts. I mportant pro ducti o n de ci si ons li ke make or buy can be take n
onl y afte r the fi nanci al i mpl i cati ons are consi de re d.

* M arke t ing - Finance : Vari ous aspe cts of marke ti ng manage me n t

have fi nanci al i mpl i cati ons, de ci si ons to hol d i nve ntori e s on l arge scal e
to pro vi de off the she l f se rvi ce to custome rs i ncre ase s i nve ntory
hol di ng cost and at the same ti me may i ncre ase sal e s, si mi l ar w i th
exte nsi on of cre di t faci l i ty to custome rs. Marke ti ng strate gi e s to
i ncre ase sal e i n most case s, have addi ti onal costs that are to be
w ei ghte d care ful l y agai nst i ncre me ntal re ve nue be fore taki ng de ci si on.

* Pe rs o nne l - Finance : I n the gl obal i se d compe ti ti ve sce nari o,

busi ne ss organi sati o ns are movi ng to a fl atte r organi sati on al structure .
I nve stme nts i n human re sou rce de ve l opme nts are al so i ncre asi ng.
Re struct uri n g of re mune rati on structure , vol untary re ti re me nt sche me s,
sw e at e qui ty, e tc. have be come maj or fi nanci al de ci si ons i n the human
re sou rce mana ge me nt.

Que s t io n : Dis cus s s o me o f t he ins t ance s ind icat ing t he chang ing
s ce nario of fi nancial manag e me nt in Ind ia ?

Ans we r : Mode rn fi nanci al manage me nt has come a l ong w ay fro m

tradi ti onal corporate fi nance , the fi nance manage r i s w orki ng i n a
chal l e ngi ng e nvi ronme n t that i s changi ng conti nuo usl y. Due to the
ope ni ng of the e conomi e s, gl obal re sou rce s are be i ng tappe d, the
opport uni ti e s avai l abl e to fi nance mana ge rs vi rtual l y have no l i mi ts, he
must al so unde rsta nd the ri sks e ntai l i ng al l hi s de ci si ons. Fi nanci al
mana ge me nt i s passi ng throu gh an e ra of expe ri me ntati on and
exci te me nt i s a part of fi nance acti vi ti e s now a days. A fe w i nstance s
are as bel ow :

i ) I nte re st rate s have bee n fre e d from re gul ati on, tre asur y ope rati ons
thus, have to be more sophi sti cate d due to fl uctuati n g i nte re st rate s.
Mi ni mum cost of capi tal ne ce ssi tate s anti ci pati ng i nte re st rate
move me nts.

i i ) The rupe e had be come ful l y conve rti bl e on curre nt account.

i i i ) O pti mum de bt e qui ty mi x i s possi bl e . Fi rms have to take advanta ge

of the fi nanci al le ve rage to i ncre ase the share hol de r 's we al th, how e ve r,
usi ng fi nanci al le ve rage ne ce ssari l y make s busi ne ss vul ne rabl e to
fi nanci al ri sk. Fi ndi ng a corre ct trade off be twe e n ri sk and i mpro ve d
re turn to share hol de rs i s a chal le ngi n g task for a fi nance manage r.

i v) Wi th fre e pri ci ng of i ssue s, the opti mum pri ce de te rmi nati on of ne w

i ssue s i s a daunti n g task as ove rpri ci ng re sul ts i n unde r subscri pti o n
and l oss of i nve stor confi de nce , w hi le unde r pri ci ng le ads to
unw arra nte d i ncre ase i n numbe r of share s the re by re duci n g the EPS.
v) Mai ntai ni n g share pri ce s i s cruci al . I n the l i be ral i se d sce nari o the
capi tal marke ts i s the i mportan t ave nue of funds for busi ne ss. Di vi de nd
and bonus pol i ci e s frame d by fi nance mana ge rs have a di re ct be ari ng
on the share pri ce s.

vi ) Ensuri ng manage me nt control is vi tal e spe ci al l y i n li ght of fore i gn

parti ci pati o n i n e qui ty, backe d by huge re source s maki ng the fi rm an
e asy take ove r targe t. Exi sti ng mana ge me nts mi ght l ose cont rol i n the
e ve ntual i ty of bei ng unabl e to take up sha re e nti tl e me nts, fi nanci al
strate gi e s, are vi tal to pre ve nt thi s.
I n a re source s constrai nt si tuati on, the i mporta nce of
fi nanci al manage me nt is hi ghl i ghte d as fi nanci al strate gi e s are re qui re d
to ge t the compa ny thro ug h the constrai nts posi ti on. The re asons for i t,
may be l ack of de mand, scarci ty of raw mate ri al s, l abour constrai nts,
e tc. If the probl e m i s not pro pe rl y de al t wi th at i ni ti al stage s, i t coul d
l e ad ul ti mate l y to bankr uptcy and si ckne ss. The fi nanci al mana ge r's
rol e i n such si tuati ons, w oul d be fi rst to asce rtai n, w he the r unde r the
ci rcums tance s, the organi sati on i s vi abl e or not. I f the vi abi l i ty of the
organi sa ti on, i tsel f i s i n doubt, the n the al te rnati ve of cl osi ng dow n
ope rati ons must be expl ore d. B ut, i n maj or case s the pro bl e m can be
sol ve d w i th pro pe r strate gi e s.

Que s t io n : What is t he re le vance o f t ime value of mo ne y in

fi nanci al d e cis io n mak ing ?

Ans we r : A fi nance manage r i s re qui re d to make de ci si ons on

i nve stme nt, fi nanci ng and di vi de nd i n vie w of the company 's
obj e cti ve s. The de ci si ons as pu rchase of asse ts or proc ure me nt of funds
i .e . the i nve stme nt/ fi nanci ng de ci si ons aff e ct the cash fl ow i n di ff e re nt
ti me pe ri ods. C ash outfl ow s w oul d be at one poi nt of ti me and i nfl ow at
some othe r poi nt of ti me , he nce, the y are not compara bl e due to the
change i n rupe e val ue of mone y. The y can be made compara bl e by
i ntro duci n g the i nte re st factor. I n the the ory of fi nance , the i nte re st
factor i s one of the cruci al and excl usi ve conce pt, know n as the ti me
val ue of mone y.
Ti me val ue of mone y me ans that w orth of a rupe e re ce i ve d
today i s di ff e re nt from the same re ce i ve d i n future . The pre fe re nce for
mone y now as compare d to future i s know n as ti me pre fe re nce of
mone y. The conce pt i s appl i cabl e to both i ndi vi dual s and busi ne ss
house s.

Re as o ns o f t ime p ref e re nce of mo ne y :

1 ) Ris k :
The re i s unce rtai nty about the re ce i pt of mone y i n future .

2 ) Pre f e re nce f o r p re s e nt co ns ump t io n :

Most of the pe rsons and compa ni e s have a pre fe re nce for pre se nt
consum pti on may be due to urge ncy of ne e d.

3 ) Inve s t me nt op po rt unit ie s :
Most of the pe rsons and compa ni e s have pre fe re nce for pre se nt mone y
be cause of avai l abi l i ti e s of opport uni ti e s of i nve stme nt for e arni ng
addi ti on al cash fl ow s.

Imp o rt ance of t ime value o f mo ne y :

The conce pt of ti me val ue of mone y hel ps i n arri vi ng at the comparabl e
val ue of the di ff e re nt rupe e amoun t ari si ng at di ff e re nt poi nts of ti me
i nto e qui vale nt val ue s of a parti cul ar poi nt of ti me , pre se nt or futu re .
The cash fl ow s ari si ng at di ff e re nt poi nts of ti me can be made
compara bl e by usi ng any one of the fol l ow i ng :
- by compoun di ng the pre se nt mone y to a future date i .e . by fi ndi ng out
the val ue of pre se nt mone y.
- by di scounti ng the futu re mone y to pre se nt date i .e . by fi ndi ng out
the pre se nt val ue (PV) of future mone y.

1 ) Te chniq ue s of co mp o und ing :

i) Fut ure value ( FV) o f a s ing le cas h fl o w :
The futu re val ue of a si ngl e cash fl ow i s de fi ne d as :

FV = PV (1 + r)n

W he re , F V = futu re val ue
PV = Pre se nt val ue
r = rate of i nte re st pe r annum
n = numbe r of ye ars for w hi ch compou ndi n g i s done .
I f, any vari abl e i .e . PV, r, n varie s, the n F V al so vari e s. I t i s ve ry
te di ous to cal cul ate the val ue of
(1 + r)n so di ff e re nt combi nati o ns are publ i she d i n the form of tabl e s.
The se may be re fe rre d for computa ti on, othe rw i se one shoul d use the
know l e dge of l ogari thms.

ii) Fut ure value of an annuit y :

An annui ty i s a se ri e s of pe ri odi c cash fl ow s, payme nts or re ce i pts, of
e qual amou nt. The pre mi um payme nts of a li fe i nsurance pol i cy, for
i nstance are an annui t y. I n ge ne ral te rms the future val ue of an annui ty
i s gi ve n as :

FVAn = A * ([(1 + r)n - 1]/r)

Where,

FVAn = Fu t u r e v a l u e o f a n a n n u i t y w h i c h h a s d u r a t i o n o f n y e a r s .

A = C o n s t a n t p e r i o d i c fl o w

r = Interest rate per period

n = Duration of the annuity

Thus, future value of an annuity is dependent on 3 variables, they being, the annual amount, rate of interest

a n d t h e t i m e p e r i o d , i f a n y o f t h e s e v a r i a b l e c h a n g e s i t w i l l c h a n g e t h e f u t u r e v a l u e o f t h e a n n u i t y. A

published table is available for various combination of the rate of interest 'r' and the time period 'n'.

2 ) Te chniq ue s of d is co unt ing :

i) Pre s e nt value of a s ing le cas h fl o w :

The pre se nt val ue of a si ngl e cash fl ow i s gi ve n as :

PV = FVn ( 1 )n
1 + r

Where,
FVn = Fu t u r e value n years hence

r = rate of interest per annum

n = number of years for which discounting is done.

Fr o m a b o v e , i t i s c l e a r t h a t p r e s e n t v a l u e o f a f u t u r e m o n e y d e p e n d s u p o n 3 v a r i a b l e s i . e . F V , t h e r a t e o f

interest and time period. The published tables for various combinations of ( 1 )n

1 + r

are available.

ii) Pre s e nt value of an annuit y :

Some ti me s i nste ad of a si ngl e cash fl ow , cash fl ow s of same amount i s
re ce i ve d for a numbe r of ye ars. The pre se nt val ue of an annui ty may be
expre sse d as be l ow :

PVAn = A/(1 + r)1 + A/(1 + r)2 + ................ + A/(1 + r)n-1 + A/(1 + r)n

= A [1/(1 + r)1 + 1/(1 + r)2 + ................ + 1/(1 + r)n-1 + 1/(1 +

n
r) ]

= A [ (1 + r)n - 1]
r(1 + r)n

Where,
PVAn = Present value of annuity which has duration of n years
A = Constant periodic fl ow
r = Discount rate.

CH APTER ON E

FIN AN CIAL M AN AGEM EN T : AN OVERVI EW

Que s t io n : What d o yo u me an b y fi nancia l manag e me nt ?

Ans we r :
M e aning o f Financ ial M anag e me nt :
The pri mary task of a C harte re d Accoun tan t i s to de al w i th
funds, 'Man age me nt of Funds ' i s an i mportan t aspe ct of fi nanci al
mana ge me nt i n a busi ne ss unde rtaki n g or any othe r i nsti tuti on l i ke
hospi tal , art soci e ty, and so on. The te rm 'Fi nanci al Manage me nt' has
be e n de fi ne d di ff e re ntl y by di ff e re nt authors.
Accordi n g to Sol omon "Fi nanci al Manage me nt i s conce rne d
w i th the e ffi ci e nt use of an i mporta nt e conomi c re sou rce , name l y
capi tal funds. " Phi l l i ppatus has gi ve n a more el aborate de fi ni ti on of
the te rm, as , "Fi nanci al Manage me nt, i s conce rne d wi th the mana ge ri al
de ci si ons that re sul ts i n the acqui si ti on and fi nanci ng of short and
l ong te rm cre di ts for the fi rm. " Thus, i t de al s w i th the si tuati ons that
re qui re se le cti on of spe ci fi c pro bl e m of si ze and grow t h of an
e nte rpri se . The anal ysi s of the se de ci si ons i s base d on the expe cte d
i nfl ow s and outfl ow s of funds and the i r eff e ct on manage ri al obj e cti ve s.
The most acce ptabl e de fi ni ti on of fi nanci al manage me n t i s that gi ve n
by S. C .Kuchhal as, "Fi nanci al mana ge me nt de al s wi th procu re me nt of
funds and thei r e ff e cti ve uti li sati on i n the busi ne ss. " Thus, the re are 2
basi c aspe cts of fi nanci al manage me nt :

1 ) p ro cure me nt o f f unds :
As funds can be obtai ne d from di ff e re nt source s thus, the i r
proc ure me n t i s al w ays consi de re d as a compl ex probl e m by busi ne ss
conce rns. The se funds proc ure d from di ff e re nt source s have di ff e re nt
characte ri sti cs i n te rms of ri sk, cost and control that a manage r must
consi de r w hi l e proc uri n g funds. The funds shoul d be procu re d at
mi ni mum cost, at a bal ance d ri sk and control factors.
Funds rai se d by i ssue of e qui ty share s are the be st from ri sk
poi nt of vi ew for the compan y, as i t has no re payme n t li abi l i ty exce pt
on wi ndi ng up of the compan y, but fro m cost poi nt of vie w , i t i s most
expe nsi ve , as di vi de nd expe ctati ons of share hol de rs are hi ghe r than
pre vai l i ng i nte re st rate s and di vi de nds are appropri ati o n of profi ts and
not al l owe d as expe nse unde r the i ncome tax act. The i ssue of ne w
e qui ty share s may di l ute the control of the exi sti ng share hol de rs.
De be nture s are compar ati ve l y che ape r si nce the i nte re st i s
pai d out of profi ts be fore tax. B ut, the y e ntai l a hi gh de gre e of ri sk
si nce the y have to be re pai d as pe r the te rms of agre e me nt; al so, the
i nte re st payme nt has to be made w he the r or not the company make s
profi ts.
Funds can al so be procu re d from banks and fi nanci al
i nsti tuti ons, the y pro vi de funds subj e ct to ce rtai n re stri cti ve cove nants.
The se cove nants re stri ct fre e dom of the borrow e r to rai se loans from
othe r source s. The re form proce ss i s al so movi ng i n di re cti on of a
cl ose r moni tori ng of 'e nd use ' of re sou rce s mobi l i se d throu gh capi tal
marke ts. Such re stri cti ons are e sse nti al for the safe ty of funds provi de d
by i nsti tuti ons and i nve stors. The re are othe r fi nanci al i nstrume nts
use d for rai si ng fi nance e. g. comme rci al pape r, dee p di scount bonds,
e tc. The fi nance manage r has to bal ance the avai l abi l i ty of funds and
the re stri cti ve provi si on s tie d wi th such funds re sul ti ng i n l ack of
fl exi bi l i ty.
 I n the gl obal i se d compe ti ti ve sce nari o, i t i s not e nough to
de pe nd on avai l abl e w ays of fi nance but re source mobi l i sati on is to be
unde rta ke n throu gh i nnovati ve w ays or fi nanci al prod ucts that may
me e t the nee ds of i nve stors. Mul ti pl e opti on conve rti bl e bonds can be
si ghte d as an exampl e , funds can be rai se d i ndi ge nousl y as al so from
abroad. Fore i gn Di re ct I nve stme nt (F DI ) and Fore i gn I nsti tuti onal
I nve stors (FI I ) are tw o maj or source s of fi nance fro m abroa d al ong wi th
Ame ri can De posi tory Re ce i pts (ADR's) and Gl obal De posi tory Re ce i pts
(GDR's). The me chani sm of proc uri ng funds i s to be modi fi e d i n the
l i ght of re qui re me nts of fore i gn i nve stors. Procu re me nt of funds i nte r
al i a i ncl ude s :

- I de nti fi cati on of source s of fi nance

- De te rmi nati o n of fi nance mi x
- Rai si n g of funds
- Di vi si on of profi ts be twe e n di vi de nds and re te nti on of profi ts i .e .
i nte rnal fund ge ne rati on.

2 ) e ff e ct ive us e o f s uch f unds :

The fi nance mana ge r is al so re sponsi bl e for e ff e cti ve uti l i sati on of
funds. He must poi nt out si tuati ons w he re funds are ke pt i dl e or are
use d i mprope rl y. Al l funds are procu re d at a ce rtai n cost and afte r
e ntai l i ng a ce rtai n amount of ri sk. If the funds are not uti l i se d i n the
manne r so that the y ge ne rate an i ncome hi ghe r than cost of
proc ure me n t, the re i s no me ani ng i n runni ng the busi ne ss. It i s an
i mporta nt consi de rati on i n di vi de nd de ci si ons al so, thus, i t i s cruci al to
e mpl oy funds prope rl y and profi t abl y. The funds are to be e mpl oye d i n
the manne r so that the company can prod uce at i ts opti mum l e ve l
w i thout e ndange ri ng i ts fi nanci al sol ve ncy. Thus, fi nanci al i mpl i cati ons
of e ach de ci si on to i nve st i n fi xe d asse ts are to be pro pe rl y anal yse d.
For thi s, the fi nance mana ge r must posse ss sound know l e dge of
te chni que s of capi tal bud ge ti ng and must ke e p i n vie w the nee d of
ade quate w orki ng capi tal and e nsure that w hi l e fi rms e nj oy an opti mum
l e ve l of w orki ng capi tal the y do not kee p too much funds bl ocke d i n
i nve ntori e s, book de bts, cash, e tc.
Fi xe d asse ts are to fi nance d from me di um or l ong te rm funds, and
not short te rm funds, as fi xe d asse ts cannot be sol d i n short te rm i. e .
w i thi n a ye ar, al so a l arge amount of funds w oul d be bl ocke d i n stock i n
hand as the company cannot i mme di ate l y se l l i ts fi ni she d goods.

Que s t io n : Ex p lain t he s cop e o f fi nanci al manag e me nt ?

Ans we r : Scop e of fi nancia l manag e me nt :

A soun d fi nanci al mana ge me nt i s esse nti al i n al l type of
fi nanci al organi sati o ns - w he the r profi t orie nte d or not, w he re funds are
i nvol ve d and al so i n a ce ntral l y pl anne d e conomy as al so i n a capi tal i st
se t-up. Fi rms, as pe r the comme rci al hi story, have not li qui date d
be cause the i r te chnol ogy w as obsol e te or the i r pro duc ts had no or l ow
de mand or due to any othe r factor, but due to l ack of fi nanci al
mana ge me nt. Eve n i n boom pe ri od, w he n a compa ny make s hi gh
profi ts, the re i s dan ge r of li qui dati o n, due to bad fi nanci al
mana ge me nt. The mai n cause of l i qui dati on of such compani e s i s ove r-
tradi n g or ove r-expandi ng w i thout an ade qua te fi nanci al base .
Fi nanci al manage me nt opti mi se s the output from the gi ve n i nput
of funds and atte mpts to use the funds i n a most prod ucti ve manne r. I n
a country li ke I ndi a, w he re re sou rce s are scarce and de mand on funds
are many, the ne e d for pro pe r fi nanci al manage me nt i s e normous. I f
pro pe r te chni que s are use d most of the e nte rpri se s can re duce the i r
capi tal e mpl oye d and i mprove re turn on i nve stme nt. Thus, as me n and
machi ne are pro pe rl y mana ge d, fi nance s are al so to be w el l manage d.
I n ne wl y starte d compani e s, i t i s i mportant to have sound
fi nanci al manage me nt, as i t e nsure s the i r survi val , ofte n such
compa ni e s i gnore s fi nanci al manage me nt at the i r ow n pe ri l . Eve n a
si mpl e act, l i ke de posi ti ng the che que s on the day of the i r re ce i pt i s
not pe rforme d. Such organi sati ons pay he avy i nte re st charge s on
borrow e d funds, but are tardy i n re al i si ng the i r ow n de btors. Thi s i s due
to the fact the y l ack re al i sati on of the conce pt of ti me val ue of mone y,
i t i s not app re ci ate d that each val ue of rupe e has to be made use of
and that i t has a di re ct cost of uti l i sati on. It must be re al i se d that
ke e pi ng rupe e i dl e eve n for a day, re sul ts i nto l osse s. A non- profi t
organi sa ti on may not be ke e n to make profi t, tradi ti on al l y, but i t doe s
ne e d to cut dow n i ts cost and use the funds at i ts di sposal to the i r
opti mu m capaci ty. A soun d se nse of fi nanci al manage me nt has to be
cul ti vate d among our bure aucr ats, admi ni strat ors, e ngi nee rs,
e ducati oni sts and publ i c at l arge . Unl e ss thi s i s done , col ossal w astage
of the capi tal re source s cannot be arre ste d.

Que s t io n : What are t he o b je ct ives o f fi nanci al manag e me nt ?

Ans we r :
Ob je ct ive s of fi nancial manag e me nt :
Effi cie nt fi nanci al mana ge me nt re qui re s exi ste nce of some
obj e cti ve s or goal s be cause j udgme nt as to w he the r or not a fi nanci al
de ci si on i s effi cie nt is to be made i n l i ght of some obj e cti ve . The tw o
mai n obj e cti ve s of fi nanci al manage me nt are :

1 ) Pro fi t M ax imis at io n :
I t i s tradi ti on al l y be i ng argue d, that the obj e cti ve of a company i s to
e arn profi t, he nce the obj e cti ve of fi nanci al mana ge me nt i s profi t
maxi mi sati on. Thus, e ach al te rnati ve , i s to be see n by the fi nance
mana ge r fro m the vie w poi nt of profi t maxi mi sati on. B ut, i t cannot be
the onl y obj e cti ve of a company, i t i s at be st a li mi te d obj e cti ve el se a
num be r of pro bl e ms w oul d ari se . Some of the m are :

a) The te rm profi t i s vague and doe s not cl ari fy w hat exactl y i t me ans.
I t conve ys di ff e re nt me ani ng to di ff e re nt pe opl e .

b) Profi t maxi mi sati on has to be atte mpte d w i th a re al i sati on of ri sks

i nvol ve d. The re i s di re ct re l ati on be tw ee n ri sk and profi t; hi ghe r the
ri sk, hi ghe r i s the profi t. For maxi mi si ng profi t, ri sk i s al toge the r
i gnore d, i mpl yi ng that fi nance manage r acce pts hi ghl y ri sky pro posal s
al so. Practi cal l y, ri sk i s a ve ry i mporta nt factor to be bal ance d wi th
profi t obj e cti ve .

c) Profi t maxi mi sati on i s an obj e cti ve not taki ng i nto account the ti me
patte rn of re turns.
E. g. Pro posal X gi ve s re turn s hi ghe r than that by propos al Y but, the
ti me pe ri od i s say, 10 ye ars and 7 ye ars re spe cti vel y. Thus, the ove ral l
profi t i s onl y consi de re d not the ti me pe ri od, nor the fl ow of profi t.

d) Profi t maxi mi sati on as an obj e cti ve i s too narrow , i t fai l s to take

i nto account the soci al consi de rati ons and obl i gati ons to vari ous
i nte re sts of w orke rs, consume rs, socie ty, as w el l as e thi cal trade
practi ce s. I gnori ng the se factors, a compa ny cannot survi ve for l ong.
Profi t maxi mi sati on at the c ost of soci al and moral obl i gati ons i s a
short si ghte d pol i cy.

2 ) We alt h max imis at io n :

The compani e s havi ng profi t maxi mi sati on as i ts obj e cti ve,
may adopt pol i ci e s yi e l di ng exorbi tan t profi ts i n the short run w hi ch are
unhe al thy for the grow th, survi val and ove ral l i nte re sts of the busi ne ss.
A compa ny may not unde rta ke pl anne d and pre scri be d shut- dow ns of
the pl ant for mai nte nance , and so on for maxi mi si ng profi ts i n the short
run. Thus, the obj e cti ve of a fi rm shoul d be to maxi mi se i ts val ue or
w e al th.
Accordi n g to Van Horne , "Val ue of a fi rm i s re pre se nte d by the
marke t pri ce of the compa ny's common stock. . .. . . . the marke t pri ce of a
fi rm's stock re p re se nts the focal j udgme nt of al l marke t parti ci pa nts as
to w hat the val ue of the parti cul ar fi rm i s. I t take s i nto account pre se nt
as al so pros pe cti ve futu re earni ngs pe r sha re , the ti mi ng and ri sk of
the se e arni ng, the di vi de nd pol i cy of the fi rm and many othe r factors
havi ng a be ari ng on the marke t pri ce of stock. The marke t pri ce se rve s
as a pe rforma nce i ndex or re port card of the fi rm's pro gre ss. I t
i ndi cate s how we ll manage me n t i s doi ng on be hal f of stockhol de rs. "
Sha re pri ce s i n the share marke t, at a gi ve n poi nt of ti me , are the
re sul t of a mi xture of many factors, as ge ne ral e conomi c outl ook,
parti cul ar outl ook of the compani e s unde r consi de rati on, te chni cal
factors and e ve n mass psychol ogy, but, take n on a l ong te rm basi s,
the y re fl e ct the val ue , w hi ch vari ous parti e s, put on the company.
N ormal l y thi s val ue i s a functi on, of :

- the l i ke l y rate of e arni ngs pe r share of the company; and

- the capi tal i sati on rate .

The l i ke l y rate of e arni ngs pe r share (EPS) de pe nds upon the

asse ssme nt as to the profi ta bl y a company i s goi ng to ope rate i n the
futu re or w hat i t i s l i kel y to earn agai nst e ach of i ts ordi nary share s.
The capi tal i sati on rate re fl e cts the li ki ng of the i nve stors of a
compa ny. I f a company e arns a hi gh rate of e arni ngs pe r share thro ug h
i ts ri sky ope rati ons or ri sky fi nanci n g patte rn, the i nve stors wi l l not
l ook upon i ts share wi th favour. To that exte nt, the marke t val ue of the
share s of such a company wi l l be l ow. An easy w ay to de te rmi ne the
capi tal i sati on rate i s to start wi th fi xe d de posi t i nte re st rate of banks,
i nve stor w oul d w ant a hi ghe r re turn i f he i nve sts i n share s, as the ri sk
i ncre ase s. How much hi ghe r re turn i s expe cte d, de pe nds on the ri sks
i nvol ve d i n the parti cul ar share w hi ch i n turn de pe nds on compa ny
pol i ci e s, past re cords, type of busi ne ss and confi de nce comman de d by
the mana ge me nt. Thus, capi tal i sati on rate i s the cumul ati ve re sul t of
the asse ssme nt of the vari ous share hol de rs re gardi n g the ri sk and
othe r qual i tati ve factors of a compan y. I f a compa ny i nve sts i ts funds i n
ri sky ve ntu re s, the i nve stors w i ll put i n the i r mone y i f the y ge t hi ghe r
re turn as compare d to that from a l ow ri sk share .
The marke t val ue of a share i s thus, a functi on of e arni ngs pe r
share and capi tal i sati on rate . Si nce the profi t maxi mi sati o n cri te ri a
cannot be appl i e d i n re al w orl d si tuati ons be cause of i ts te chni cal
l i mi tati on the fi nance manage r of a compa ny has to e nsure that hi s
de ci si ons are such that the marke t val ue of the share s of the compa ny
i s maxi mum i n the l ong run. Thi s i mpl i e s that the fi nanci al pol i cy has to
be suc h that i t opti mi se s the EPS, kee pi ng i n vi ew the ri sk and othe r
factors. Thus, w e al th maxi mi sati on i s a be tte r obj e cti ve for a
comme rci al unde rtaki n g as compare d to re turn and ri sk.
The re i s a grow i ng e mphasi s on soci al and othe r obl i gati ons of
an e nte rpri se . I t cannot be de ni e d that i n the case of unde rtaki ngs,
e spe ci all y those i n the publ i c se ctor, the que sti on of w e al th
maxi mi sati on i s to be see n i n context of soci al and othe r obl i gati ons of
the e nte rpri se .
I t must be unde rsto od that fi nanci al de ci si on maki ng i s re l ate d
to the obj e cti ve s of the busi ne ss. The fi nance mana ge r has to e nsure
that the re i s a posi ti ve i mpact of e ach fi nanci al de ci si on on the
furthe rance of the busi ne ss obj e cti ve s. O ne of the mai n obj e cti ve of an
unde rtaki n g may be to "prog re ssi ve l y bui l d up the capabi l i ty to
unde rta ke the de si gn and de ve l opme nt of ai rcraft e ngi ne s, he l i copte rs,
e tc. " A fi nance manage r i n such case s w i ll al l ocate funds i n a w ay that
thi s obje cti ve i s achi e ve d al thou gh such an al l ocati on may not
ne ce ssari l y maxi mi se we al th.

Que s t io n : What are t he f unct io ns of a Finance M anag e r ?

Ans we r :
Funct io ns o f a Finance M anag e r :
The tw i n aspe cts, proc ure me nt and eff e cti ve uti l i sati on of
funds are cruci al tasks face d by a fi nance mana ge r. The fi nanci al
mana ge r i s re qui re d to l ook i nto the fi nanci al i mpl i cati ons of any
de ci si on i n the fi rm. Thus al l de ci si ons i nvol ve manage me n t of funds
unde r the purvi e w of the fi nance manage r. A l arge numbe r of de ci si ons
i nvol ve substan ti al or mate ri al change s i n val ue of fund s procu re d or
e mpl oye d. The fi nance mana ge r, has to manage funds i n such a w ay so
as to make the i r opti mum uti l i sati on and to e nsure the i r proc ure me nt i n
a w ay that the ri sk, cost and control are pro pe rl y bal ance d unde r a
gi ve n si tuati on. He may not, be conce rne d wi th the de ci si ons, that do
not aff e ct the basi c fi nanci al mana ge me nt and structure .
The natu re of job of an accounta nt and fi nance manage r i s
di ff e re nt, an accountan t's job i s pri mari l y to re cord the busi ne ss
transacti o ns, pre pare fi nanci al state me nts show i ng re sul ts of the
organi sa ti on for a gi ve n pe ri od and i ts fi nanci al condi ti on at a gi ve n
poi nt of ti me . He i s to re cord vari ous hap pe ni ngs i n mone tary te rms to
e nsure that asse ts, l i abi l i tie s, i ncome s and expe nse s are pro pe rl y
gro upe d, cl assi fi e d and di scl ose d i n the fi nanci al state me nts.
Accoun tan t i s not conce rne d w i th mana ge me nt of funds that i s a
spe ci al i se d task and i n mode rn ti me s a compl ex one . The fi nance
mana ge r or cont rol l e r has a task e nti re l y di ff e re nt from that of an
account ant, he i s to manage funds. Some of the i mportan t de ci si ons as
re gards fi nance are as fol l ow s :

1 ) Es t imat ing t he re q uire me nt s of f und s : A busi ne ss re qui re s

funds for l ong te rm purpose s i. e. i nve stme nt i n fi xe d asse ts and so on.
A care ful e sti mate of such funds i s re qui re d to be made . An
asse ssme nt has to be made re gardi n g re qui re me nts of w orki ng capi tal
i nvol vi ng, esti mati on of amount of funds bl ocke d i n curre nt asse ts and
that l i kel y to be ge ne rate d for short pe ri ods throu gh curre n t li abi l i ti e s.
Fore casti ng the re qui re me nts of fund s i s done by use of te chni que s of
bud ge tary control and l ong range pl anni ng. Esti mate s of re qui re me nts
of funds can be made onl y if al l the physi cal acti vi ti e s of the
organi sa ti on are fore caste d. The y can be transl ate d i nto mone tary
te rms.

2 ) De cis io n re g ard ing cap it al s t ruct ure : O nce the re qui re me n ts of

funds is e sti mate d, a de ci si on re gardi ng vari ous source s from w he re the
funds w oul d be rai se d is to be take n. A prope r mi x of the vari ous
source s i s to be w orke d out, e ach source of funds i nvol ve s di ff e re nt
i ssue s for consi de rati on. The fi nance manage r has to care ful l y l ook i nto
the exi sti ng capi tal structu re and se e how the vari ous pro posal s of
rai si ng funds w il l aff e ct i t. He i s to mai ntai n a pro pe r bal ance be tw ee n
l ong and short te rm funds and to e nsure that suffi ci e nt l ong- te rm fund s
are rai se d i n orde r to fi nance fi xe d asse ts and othe r l ong- te rm
i nve stme nts and to provi de for pe rmane nt ne e ds of w orki ng capi tal . I n
the ove ral l vol ume of l ong- te rm funds, he i s to mai ntai n a prope r
bal ance be twe e n ow n and l oan funds and to se e that the ove ral l
capi tal i sati on of the compa ny i s such, that the company is abl e to
proc ure funds at mi ni mum cost and i s abl e to tol e rate shocks of le an
pe ri ods. Al l the se de ci si ons are know n as 'fi nanci ng de ci si ons'.

3 ) Inve s t me nt de cis io n : Funds procu re d fro m di ff e re nt source s have

to be i nve ste d i n vari ous ki nds of asse ts. Long te rm funds are use d i n a
proj e ct for fi xe d and al so curre nt asse ts. The i nve stme nt of fund s i n a
proj e ct i s to be made afte r care ful asse ssme nt of vari ous proj e cts
thro ug h capi tal budge ti ng. A part of l ong te rm funds is al so to be ke pt
for fi nanci n g w orki ng capi tal re qui re me nts. Asse t mana ge me nt pol i cie s
are to be l ai d dow n re gardi ng vari ous i te ms of curre nt asse ts, i nve ntory
pol i cy i s to be de te rmi ne d by the produc ti on and fi nance manage r,
w hi le ke e pi ng i n mi nd the re qui re me n t of prod ucti on and future pri ce
e sti mate s of raw mate ri al s and avai l abi l i ty of fund s.

4 ) Divid e nd de cis io n : The fi nance manage r i s conce rne d w i th the

de ci si on to pay or de cl are di vi de nd. He i s to assi st the top manage me nt
i n de ci di ng as to w hat amount of di vi de nd shoul d be pai d to the
share hol de rs and w hat amount be re tai ne d by the compa ny, i t i nvol ve s
a l arge num be r of consi de rati ons. Economi cal l y spe aki ng, the amou nt
to be re tai ne d or be pai d to the share hol de rs shoul d de pe nd on w he the r
the compan y or share hol de rs can make a more profi ta bl e use of
re sou rce s, al so consi de rati ons l i ke tre nd of e arni ngs, the tre nd of share
marke t pri ce s, re qui re me nt of funds for future grow th, cash fl ow
si tuati on, tax posi ti on of sha re hol de rs, and so on to be ke pt i n mi nd.
The pri nci pal func ti on of a fi nance manage r re l ate s to
de ci si ons re gardi ng procure me nt, i nve stme nt and di vi de nds.

5 ) Sup p ly of f und s to all p art s o f t he o rg anis at io n o r cas h

manag e me nt : The fi nance manage r has to e nsure that al l se cti ons
i .e . branche s, factori e s, uni ts or de partme nts of the orga ni sati on are
suppl i e d w i th ade quate funds. Se cti ons havi ng exce ss funds contri bu te
to the ce ntral pool for use i n othe r se cti ons that nee ds funds. An
ade quate suppl y of cash at al l poi nts of ti me i s absol ute l y esse nti al for
the smooth fl ow of busi ne ss ope rati ons. Eve n i f one of the many
branche s i s short of funds, the w hole busi ne ss may be i n dange r, thus,
cash manage me nt and cash di sburse me nt pol i ci e s are i mportant wi th a
vi ew to suppl yi n g ade quate funds at all ti me s and poi nts i n an
organi sa ti on. I t shoul d e nsure that the re i s no exce ssi ve cash.

6 ) Evalu at ing fi nancia l pe rf o rmance : Manage me nt control syste ms

are usual l y base d on fi nanci al anal ysi s, e. g. RO I (re turn on i nve stme nt)
syste m of di vi si onal control . A fi nance manage r has to constan tl y
re vi e w the fi nanci al pe rformance of vari ous uni ts of the orga ni sati on.
Anal ysi s of the fi nanci al pe rformance he l ps the mana ge me nt for
asse ssi ng how the funds are uti l i se d i n vari ous di vi si ons and w hat can
be done to i mprove i t.

7 ) Financ ial neg o t iat io ns : Fi nance manage r' s maj or ti me i s uti l i se d

i n carryi ng out ne goti ati ons w i th fi nanci al i nsti tuti ons, banks and publ i c
de posi tors. He has to furni sh a l ot of i nformati o n to the se i nsti tuti ons
and pe rsons i n orde r to e nsure that rai si ng of funds is w i thi n the
statute s. Ne goti ati ons for outsi de fi nanci ng ofte n re qui re s spe ci al i se d
ski l l s.

8 ) Ke e p ing in t o uch wit h st o ck e x chang e q uo t at io ns and

b e havio r of share p rice s : I t i nvol ve s anal ysi s of maj or tre nds i n the
stock marke t and j udgi ng thei r i mpact on share pri ce s of the company 's
share s.

Que s t io n : What are t he vario us met ho ds and t oo ls us ed fo r

fi nanci al manag e me nt ?

Ans we r : Fi nance manage r use s vari ous tool s to di scharge hi s

functi ons as re gards fi nanci al manage me nt. I n the are a of fi nanci ng
the re are vari ous me thods to procu re funds from l ong as al so short
te rm source s. The fi nance manage r has to de ci de an opti mum capi tal
structu re that can contri bu te to the maxi mi sati o n of share hol de r's
w e al th. Fi nanci al l e ve rage or tradi ng on e qui ty i s an i mporta nt me thod
by w hi ch a fi nance manage r may i ncre ase the re turn to commo n
share hol de rs.
For e val uati on of capi tal pro posal s, the fi nance manage r
use s capi tal budge ti ng te chni que s as payb ack, i nte rnal rate of re turn,
ne t pre se nt val ue , profi ta bi l i ty i ndex, ave rage rate of re turn. I n the
are a of curre nt asse ts mana ge me nt, he use s me thods to che ck e ffi ci e nt
uti l i sati on of curre nt re source s at the e nte rpri se 's di sposal . An
e nte rpri se can i ncre ase i ts profi t abi l i ty wi thout aff e cti ng i ts li qui di ty by
an effi cie nt manage me nt of w orki ng capi tal . For i nstance , i n the are a of
w orki ng capi tal manage me n t, cash manage me nt may be ce ntral i se d or
de -ce ntral i se d; ce ntral i se d me thod i s consi de re d a be tte r tool of
mana gi ng the e nte rpri se 's l i qui d re source s. I n the are a of di vi de nd
de ci si ons, a fi rm i s face d w i th the pro bl e m of de cl arati on or postpo ni ng
de cl arati on of di vi de nd, a probl e m of i nte rnal fi nanci n g.

For e val uati on of an e nte rpri se 's pe rforma nce , the re are
vari ous me thods, as rati o anal ysi s. Thi s te chni que i s use d by al l
conce rne d pe rsons. Di ff e re nt rati os se rvi ng di ff e re nt obj e cti ve s. An
i nve stor use s vari ous rati os to e val uate the profi t abi l i ty of i nve stme nt
i n a parti cul ar compa ny. The y e nabl e the i nve stor, to j udge the
profi tabi l i ty, sol ve ncy, li qui di ty and grow t h aspe cts of the fi rm. A short-
te rm cre di tor i s more i nte re ste d i n the li qui di ty aspe ct of the fi rm, and
i t i s possi bl e by a study of l i qui di ty rati os - curre nt rati o, qui ck rati os,
e tc. The mai n conce rn of a fi nance manage r i s to provi de ade quate
funds from be st possi bl e source , at the ri ght ti me and at mi ni mum cost
and to e nsure that the funds so acqui re d are put to be st possi bl e use .
Funds fl ow and cash fl ow state me nts and proj e cte d fi nanci al state me nts
he l p a l ot i n thi s re gard.

Que s t io n : Dis cus s t he ro le of a fi nance manag e r ?

Ans we r : In the mode rn e nte rpri se , a fi nance manage r occupi e s a ke y

posi ti on, he bei ng one of the dynami c me mbe r of corporate manage ri al
te am. Hi s rol e , i s be comi ng more and more pe rvasi ve and si gni fi cant i n
sol vi ng compl ex mana ge ri al pro bl e ms. Tradi ti on al l y, the rol e of a
fi nance manage r w as confi ne d to rai si ng funds fro m a numbe r of
source s, but due to re ce nt de ve l opme nts i n the soci o - economi c and
pol i ti cal sce nari o thro ug hou t the w orl d, he i s pl ace d i n a ce ntral
posi ti on i n the organi sati o n. He i s re sponsi bl e for shapi ng the fortune s
of the e nte rpri se and is i nvol ve d i n the most vi tal de ci si on of al l ocati on
of capi tal li ke me rge rs, acqui si ti ons, etc. A fi nance mana ge r, as othe r
me mbe rs of the corporate te am cannot be ave rse to the fast
de ve l opme nts, aroun d hi m and has to take note of the change s i n orde r
to take re le vant ste ps i n vie w of the dynami c change s i n
ci rcums tance s. E. g. i ntrod ucti on of Euro - as a si ngl e curre nc y of
Euro pe is an i nte rnati onal le vel change , havi ng i mpact on the corporate
fi nanci al pl ans and pol i ci e s w orl d-w i de.
Dome sti c de ve l opme nts as e me rge nce of fi nanci al se rvi ce s
se ctors and SEB I as a w atch dog for i nve stor pro te cti on and re gul ati n g
body of capi tal marke ts is contri bu ti ng to the i mportance of the fi nanc e
mana ge r's j ob. B anks and fi nanci al i nsti tuti on s we re the maj or source s
of fi nance , mono pol y w as the state of aff ai rs of I ndi an busi ne ss,
share hol de rs sati sfacti on w as not the pro mote r's conce rn as most of
the compani e s, we re cl osel y he l d. Due to the ope ni ng of economy,
compe ti ti on i ncre ase d, se l le r's marke t i s bei ng conve rte d i nto buye r's
marke t. De ve l opme nt of i nte rne t has bro ug ht ne w chal l e nge s be fore the
mana ge rs. I ndi an conce rns no l onge r have to compe te onl y nati onal l y,
i t i s faci ng i nte rnati on al compe ti ti on. Thus a ne w e ra i s ushe re d duri ng
the re ce nt ye ars, i n fi nanci al manage me nt, spe ci al l y, w i th the
de ve l opme nt of fi nanci al tool s, te chni que s, i nstrume nts and prod ucts.
Al so due to i ncre asi ng e mphasi s on publ i c se ctor unde rtaki ngs to be
se l f-supp orti n g and the i r de pe nde nce on capi tal marke t for fund
re qui re me nts and the i ncre asi ng si gni fi cance of li be ral i sati on,
gl obal i sati on and de re gul ati on.

Que s t io n : Draw a t yp ical o rg anis at io n chart hig hlig ht ing t he

fi nance f unct io n of a co mp any ?

Ans we r : The fi nance functi on i s the same i n al l e nte rpri se s, de tai l s

may di ff e r, but maj or fe ature s are uni ve rsal i n nature . The fi nance
functi on occupi e s a si gni fi cant posi ti on i n an organi sa ti on and i s not
the re sponsi bi l i ty of a sole exe cuti ve . The i mporta nt aspe cts of fi nance
mana ge r are to carri e d on by top mana ge me nt i .e . managi n g di re ctor,
chai rma n, board of di re ctors. The board of di re ctors take s de ci si ons
i nvol vi ng fi nanci al consi de rati ons, the fi nanci al control l e r i s basi cal l y
me ant for assi sti ng the top manage me nt and has an i mportan t rol e of
contri bu ti ng to good de ci si on maki ng on i ssue s i nvol vi ng all functi onal
are as of busi ne ss. He i s to bri ng out fi nanci al i mpl i cati ons of all
de ci si ons and make the m unde rstood. He may be cal le d as the fi nanci al
control l e r, vi ce -pre si de nt (fi nance ), chi e f accounta nt, tre asure r, or by
any othe r de si gnati on, but has the pri mary re spon si bi l i ty of pe rformi ng
fi nance functi ons. He i s to di scharge the re sponsi bi l i ty kee pi ng i n vi ew
the ove ral l outl ook of the organi sa ti on.

BOARD OF DIRECTORS

PRESI DEN T

V. P. (Produc ti on) V. P. (Fi nance ) V. P. (Sal e s)

Tre asu re r C ontrol l e r

C re di t C ash B anki ng Portfol i C orporate Taxe I nte rna B udge ti n

Mgmt. Mgmt. re l ati on o Mgmt. Ge ne ral & s l Audi t g
s C ost
Accounti n g
 Org anis at io n chart of fi nance funct io n

The C hi e f fi nance exe cuti ve w orks di re ctl y unde r the Pre si de nt or

Managi ng Di re ctor of the company. Be si de s routi ne w ork, he kee ps the
B oard i nforme d about al l phase s of busi ne ss acti vi ty, i ncl usi ve of
e conomi c, soci al and pol i ti c al de ve l opme nts aff e cti ng the busi ne ss
be havi our and from ti me to ti me furni she s i nformati on about the
fi nanci al status of the compan y. Hi s functi ons are : (i ) Tre asur y
functi ons and (i i ) C ontrol functi ons.

Re lat io ns hip Be t we e n fi nanci al manag e me nt and ot he r are as of

manag e me nt : The re i s cl ose re l ati onshi p be twe e n the are as of
fi nanci al and othe r manage me nt li ke prod ucti on, sal e s, marke ti ng,
pe rsonne l , e tc. Al l acti vi ti e s di re ctl y or i ndi re ctl y i nvol ve acqui si ti on
and use of funds. De te rmi nati o n of prod ucti on, proc ure me nt and
marke ti ng strate gi e s are the i mportant pre rog ati ve s of the re spe cti ve
de partme nt he ads, but for i mpl e me nti ng, the i r de ci si ons funds are
re qui re d. Li ke , re pl ace me nt of fi xe d asse ts for i mpro vi ng pro duc ti on
capaci ty re qui re s funds. Si mi l arl y, the pu rchase and sal e s pro moti o n
pol i ci e s are l ai d dow n by the purch ase and marke ti ng di vi si ons
re spe cti ve l y, but agai n procu re me nt of raw mate ri al s, adve rti si ng and
othe r sal e s promo ti on re qui re funds. Same i s for, re crui tme nt and
pro moti on of staff by the pe rsonne l de partme n t w oul d re qui re funds for
payme nt of sal arie s, w age s and othe r be ne fi ts. It may, many ti me s, be
di ffi cul t to de marcate w he re one functi on e nds and othe r starts.
Al thou gh, fi nance functi o n has a si gni fi cant i mpact on the othe r
functi ons, i t ne e d not l i mi t or obstruct the ge ne ral functi ons of the
busi ne ss. A fi rm faci ng fi nanci al di ffi cul tie s, may gi ve w ei ghtage to
fi nanci al consi de rati ons and de vi se i ts ow n pro ducti o n and marke ti ng
strate gi e s to sui t the si tuati on. W hi l e a fi rm havi ng surpl us fi nance ,
w oul d have comparati ve l y l ow e r ri gi di ty as re gards the fi nanci al
consi de rati ons vi s- a-vi s othe r functi ons of the mana ge me nt.

Pe rvas ive N at ure o f Finance Funct io n : Fi nance is the l i fe bl ood of

of an organi sati o n, i t i s the common thre ad bi ndi ng al l organi sati on al
functi ons. Thi s i nte rface can be expl ai ne d as bel ow :

* Pro d uct io n - Finance : Prod ucti on functi on re qui re s a l arge

i nve stme nt. Produc ti ve use of re sou rce s e nsure s a cost advan tage for
the fi rm. O pti mum i nve stme nt i n i nve ntori e s i mprove s profi t margi ns.
Many parame te rs of prod ucti on have an i mpact on cost and can
possi bl y be control l e d throu gh i nte rnal manage me nt, thus e nhanci ng
profi ts. I mportant pro ducti o n de ci si ons li ke make or buy can be take n
onl y afte r the fi nanci al i mpl i cati ons are consi de re d.

* M arke t ing - Finance : Vari ous aspe cts of marke ti ng manage me n t

have fi nanci al i mpl i cati ons, de ci si ons to hol d i nve ntori e s on l arge scal e
to pro vi de off the she l f se rvi ce to custome rs i ncre ase s i nve ntory
hol di ng cost and at the same ti me may i ncre ase sal e s, si mi l ar w i th
exte nsi on of cre di t faci l i ty to custome rs. Marke ti ng strate gi e s to
i ncre ase sal e i n most case s, have addi ti onal costs that are to be
w ei ghte d care ful l y agai nst i ncre me ntal re ve nue be fore taki ng de ci si on.
* Pe rs o nne l - Finance : I n the gl obal i se d compe ti ti ve sce nari o,
busi ne ss organi sati o ns are movi ng to a fl atte r organi sati on al structure .
I nve stme nts i n human re sou rce de ve l opme nts are al so i ncre asi ng.
Re struct uri n g of re mune rati on structure , vol untary re ti re me nt sche me s,
sw e at e qui ty, e tc. have be come maj or fi nanci al de ci si ons i n the human
re sou rce mana ge me nt.

Que s t io n : Dis cus s s o me o f t he ins t ance s ind icat ing t he chang ing
s ce nario of fi nancial manag e me nt in Ind ia ?

Ans we r : Mode rn fi nanci al manage me nt has come a l ong w ay fro m

tradi ti onal corporate fi nance , the fi nance manage r i s w orki ng i n a
chal l e ngi ng e nvi ronme n t that i s changi ng conti nuo usl y. Due to the
ope ni ng of the e conomi e s, gl obal re sou rce s are be i ng tappe d, the
opport uni ti e s avai l abl e to fi nance mana ge rs vi rtual l y have no l i mi ts, he
must al so unde rsta nd the ri sks e ntai l i ng al l hi s de ci si ons. Fi nanci al
mana ge me nt i s passi ng throu gh an e ra of expe ri me ntati on and
exci te me nt i s a part of fi nance acti vi ti e s now a days. A fe w i nstance s
are as bel ow :

i ) I nte re st rate s have bee n fre e d from re gul ati on, tre asur y ope rati ons
thus, have to be more sophi sti cate d due to fl uctuati n g i nte re st rate s.
Mi ni mum cost of capi tal ne ce ssi tate s anti ci pati ng i nte re st rate
move me nts.

i i ) The rupe e had be come ful l y conve rti bl e on curre nt account.

i i i ) O pti mum de bt e qui ty mi x i s possi bl e . Fi rms have to take advanta ge

of the fi nanci al le ve rage to i ncre ase the share hol de r 's we al th, how e ve r,
usi ng fi nanci al le ve rage ne ce ssari l y make s busi ne ss vul ne rabl e to
fi nanci al ri sk. Fi ndi ng a corre ct trade off be twe e n ri sk and i mpro ve d
re turn to share hol de rs i s a chal le ngi n g task for a fi nance manage r.

i v) Wi th fre e pri ci ng of i ssue s, the opti mum pri ce de te rmi nati on of ne w

i ssue s i s a daunti n g task as ove rpri ci ng re sul ts i n unde r subscri pti o n
and l oss of i nve stor confi de nce , w hi le unde r pri ci ng le ads to
unw arra nte d i ncre ase i n numbe r of share s the re by re duci n g the EPS.

v) Mai ntai ni n g share pri ce s i s cruci al . I n the l i be ral i se d sce nari o the
capi tal marke ts i s the i mportan t ave nue of funds for busi ne ss. Di vi de nd
and bonus pol i ci e s frame d by fi nance mana ge rs have a di re ct be ari ng
on the share pri ce s.

vi ) Ensuri ng manage me nt control is vi tal e spe ci al l y i n li ght of fore i gn

parti ci pati o n i n e qui ty, backe d by huge re source s maki ng the fi rm an
e asy take ove r targe t. Exi sti ng mana ge me nts mi ght l ose cont rol i n the
e ve ntual i ty of bei ng unabl e to take up sha re e nti tl e me nts, fi nanci al
strate gi e s, are vi tal to pre ve nt thi s.
 I n a re source s constrai nt si tuati on, the i mporta nce of
fi nanci al manage me nt is hi ghl i ghte d as fi nanci al strate gi e s are re qui re d
to ge t the compa ny thro ug h the constrai nts posi ti on. The re asons for i t,
may be l ack of de mand, scarci ty of raw mate ri al s, l abour constrai nts,
e tc. If the probl e m i s not pro pe rl y de al t wi th at i ni ti al stage s, i t coul d
l e ad ul ti mate l y to bankr uptcy and si ckne ss. The fi nanci al mana ge r's
rol e i n such si tuati ons, w oul d be fi rst to asce rtai n, w he the r unde r the
ci rcums tance s, the organi sati on i s vi abl e or not. I f the vi abi l i ty of the
organi sa ti on, i tsel f i s i n doubt, the n the al te rnati ve of cl osi ng dow n
ope rati ons must be expl ore d. B ut, i n maj or case s the pro bl e m can be
sol ve d w i th pro pe r strate gi e s.

Que s t io n : What is t he re le vance o f t ime value of mo ne y in

fi nanci al d e cis io n mak ing ?

Ans we r : A fi nance manage r i s re qui re d to make de ci si ons on

i nve stme nt, fi nanci ng and di vi de nd i n vie w of the company 's
obj e cti ve s. The de ci si ons as pu rchase of asse ts or proc ure me nt of funds
i .e . the i nve stme nt/ fi nanci ng de ci si ons aff e ct the cash fl ow i n di ff e re nt
ti me pe ri ods. C ash outfl ow s w oul d be at one poi nt of ti me and i nfl ow at
some othe r poi nt of ti me , he nce, the y are not compara bl e due to the
change i n rupe e val ue of mone y. The y can be made compara bl e by
i ntro duci n g the i nte re st factor. I n the the ory of fi nance , the i nte re st
factor i s one of the cruci al and excl usi ve conce pt, know n as the ti me
val ue of mone y.
Ti me val ue of mone y me ans that w orth of a rupe e re ce i ve d
today i s di ff e re nt from the same re ce i ve d i n future . The pre fe re nce for
mone y now as compare d to future i s know n as ti me pre fe re nce of
mone y. The conce pt i s appl i cabl e to both i ndi vi dual s and busi ne ss
house s.

Re as o ns o f t ime p ref e re nce of mo ne y :

1 ) Ris k :
The re i s unce rtai nty about the re ce i pt of mone y i n future .

2 ) Pre f e re nce f o r p re s e nt co ns ump t io n :

Most of the pe rsons and compa ni e s have a pre fe re nce for pre se nt
consum pti on may be due to urge ncy of ne e d.

3 ) Inve s t me nt op po rt unit ie s :
Most of the pe rsons and compa ni e s have pre fe re nce for pre se nt mone y
be cause of avai l abi l i ti e s of opport uni ti e s of i nve stme nt for e arni ng
addi ti on al cash fl ow s.

Imp o rt ance of t ime value o f mo ne y :

The conce pt of ti me val ue of mone y hel ps i n arri vi ng at the comparabl e
val ue of the di ff e re nt rupe e amoun t ari si ng at di ff e re nt poi nts of ti me
i nto e qui vale nt val ue s of a parti cul ar poi nt of ti me , pre se nt or futu re .
The cash fl ow s ari si ng at di ff e re nt poi nts of ti me can be made
compara bl e by usi ng any one of the fol l ow i ng :
- by compoun di ng the pre se nt mone y to a future date i .e . by fi ndi ng out
the val ue of pre se nt mone y.
- by di scounti ng the futu re mone y to pre se nt date i .e . by fi ndi ng out
the pre se nt val ue (PV) of future mone y.

1 ) Te chniq ue s of co mp o und ing :

i) Fut ure value ( FV) o f a s ing le cas h fl o w :
The futu re val ue of a si ngl e cash fl ow i s de fi ne d as :

FV = PV (1 + r)n

W he re , F V = futu re val ue
PV = Pre se nt val ue
r = rate of i nte re st pe r annum
n = numbe r of ye ars for w hi ch compou ndi n g i s done .
I f, any vari abl e i .e . PV, r, n varie s, the n F V al so vari e s. I t i s ve ry
te di ous to cal cul ate the val ue of
(1 + r)n so di ff e re nt combi nati o ns are publ i she d i n the form of tabl e s.
The se may be re fe rre d for computa ti on, othe rw i se one shoul d use the
know l e dge of l ogari thms.

ii) Fut ure value of an annuit y :

An annui ty i s a se ri e s of pe ri odi c cash fl ow s, payme nts or re ce i pts, of
e qual amou nt. The pre mi um payme nts of a li fe i nsurance pol i cy, for
i nstance are an annui t y. I n ge ne ral te rms the future val ue of an annui ty
i s gi ve n as :

FVAn = A * ([(1 + r)n - 1]/r)

Where,

FVAn = Fu t u r e v a l u e o f a n a n n u i t y w h i c h h a s d u r a t i o n o f n y e a r s .

A = C o n s t a n t p e r i o d i c fl o w

r = Interest rate per period

n = Duration of the annuity

Thus, future value of an annuity is dependent on 3 variables, they being, the annual amount, rate of interest

a n d t h e t i m e p e r i o d , i f a n y o f t h e s e v a r i a b l e c h a n g e s i t w i l l c h a n g e t h e f u t u r e v a l u e o f t h e a n n u i t y. A

published table is available for various combination of the rate of interest 'r' and the time period 'n'.

2 ) Te chniq ue s of d is co unt ing :

i) Pre s e nt value of a s ing le cas h fl o w :

The pre se nt val ue of a si ngl e cash fl ow i s gi ve n as :

PV = FVn ( 1 )n
1 + r
Where,
FVn = Fu t u r e value n years hence

r = rate of interest per annum

n = number of years for which discounting is done.

Fr o m a b o v e , i t i s c l e a r t h a t p r e s e n t v a l u e o f a f u t u r e m o n e y d e p e n d s u p o n 3 v a r i a b l e s i . e . F V , t h e r a t e o f

interest and time period. The published tables for various combinations of ( 1 )n

1 + r

are available.

ii) Pre s e nt value of an annuit y :

Some ti me s i nste ad of a si ngl e cash fl ow , cash fl ow s of same amount i s
re ce i ve d for a numbe r of ye ars. The pre se nt val ue of an annui ty may be
expre sse d as be l ow :

PVAn = A/(1 + r)1 + A/(1 + r)2 + ................ + A/(1 + r)n-1 + A/(1 + r)n

= A [1/(1 + r)1 + 1/(1 + r)2 + ................ + 1/(1 + r)n-1 + 1/(1 +

n
r) ]

= A [ (1 + r)n - 1]
r(1 + r)n

Where,
PVAn = Present value of annuity which has duration of n years
A = Constant periodic fl ow
r = Discount rate.

CH APTER TH REE

TOOL S OF FIN AN CIAL AN ALYSIS AN D PL AN N IN G

Que s t io n : Writ e a no t e on Financ ial St at e me nt Analys is ?

Ans we r : The basi s of fi nanci al anal ysi s, pl anni ng and de ci si on maki ng

i s fi nanci al i nforma ti on. A fi rm pre pare s fi nal account s vi z. B al ance
She e t and Profi t and Loss Account provi di ng i nforma ti on for de ci si on
maki ng. Fi nanci al i nformati on i s nee de d to pre di ct, compare and
e val uate the fi rm's e arni ng abi l i ty. Profi t and Loss account show s the
conce rn's ope rati ng acti vi tie s and the B al ance She e t de pi cts the
bal ance val ue of the acqui re d asse ts and of l i abi l i tie s at a parti cul ar
poi nt of ti me . Howe ve r, the se state me nts do not di scl ose al l of the
ne ce ssary and re l e vant i nforma ti on. For the purpose of obtai ni ng the
mate ri al and re l e vant i nformati on ne ce ssary for asce rtai ni ng of
fi nanci al stre ngt hs and we akne sse s of an e nte rpri se , i t i s esse nti al to
anal yse the data de pi cte d i n the fi nanci al state me nt. The fi nanci al
mana ge r have ce rtai n anal yti cal tool s that he l p i n fi nanci al anal ysi s
and pl anni n g. I n addi ti on to studyi ng the past fl ow , the fi nanci al
mana ge r can e val uate future fl ow s by me ans of funds state me nt base d
on fore casts.
Fi nanci al State me nt Anal ysi s is the proce ss of i de nti fyi ng the
fi nanci al stre ngt h and we akne ss of a fi rm from the avai l abl e accounti ng
data and fi nanci al state me nts. I t i s done by pro pe rl y e stabl i shi ng
re l ati onshi p be twe e n the i te ms of bal ance she e t and profi t and l oss
account as,

1 ) The task of fi nanci al anal ysts i s to de te rmi ne the i nformati on

re l e vant to the de ci si on unde r consi de rati on fro m total i nformati o n
contai ne d i n the fi nanci al state me nt.

2 ) To arrange i nformati on i n a w ay to hi ghl i gh t si gni fi cant re l ati onshi ps.

3 ) I nte rpre tati o n and draw i ng of i nfe re nce s and concl usi on. Thus,
fi nanci al anal ysi s i s the proce ss of se l e cti on, re l ati on and e val uati on of
the accounti n g data/ i nformati o n.

Purp o s es o f Financi al St at e me nt Analys is : Fi nanci al State me nt

Anal ysi s i s the me ani ngf ul i nte rpre tati on of 'Fi nanci al State me nts' for
'Par ti e s De mandi n g Fi nanci al I nformati o n', such as :

1 ) The Gove rnme nt may be i nte re ste d i n know i ng the comparati ve

e ne rgy consum pti on of some pri vate and publ i c se ctor ce me nt
compa ni e s.

2 ) A nati onal i se d bank may may be ke e n to know the possi bl e de bt

cove rage out of profi t at the ti me of l e ndi ng.

3 ) Prospe cti ve i nve stors may be de si rous to know the actual and
fore caste d yi el d data.

4 ) C ustome rs w ant to know the busi ne ss vi abi l i ty pri or to e nte ri ng i nto

a l ong- te rm contract.
The re are othe r purpose s al so, i n ge ne ral, the purpose of
fi nanci al state me nt anal ysi s ai ds de ci si on maki ng by use rs of accounts.

St e ps fo r fi nanci al s t at e me nt analys is :
I de nti fi cati on of the use r's purpose
I de nti fi cati on of data source , w hi ch part of the annu al re port or
othe r i nforma ti on i s re qui re d to be anal yse d to sui t the purpo se
Se l e cti ng the te chni que s to be use d for such anal ysi s
As such anal ysi s i s purpo si ve , i t may be re stri cte d to any
parti cul ar porti on of the avai l abl e fi nanci al state me nt, taki ng care to
e nsure obj e cti vi ty and unbi ase dne ss. It cove rs study of re l ati onshi ps
w i th a se t of fi nanci al state me nts at a poi nt of ti me and wi th tre nds, i n
the m, ove r ti me . I t cove rs a study of some compara bl e fi rms at a
parti cul ar ti me or of a parti cul ar fi rm ove r a pe ri od of ti me or may
cove r both.

Typ e s of Financia l s t at e me nt analys is : The mai n obj e cti ve of

fi nanci al anal ysi s i s to de te rmi ne the fi nanci al he al th of a busi ne ss
e nte rpri se , w hi ch may be of the fol l owi ng type s :

1 ) Ex t e rnal analys is : It i s pe rforme d by outsi de parti e s, such as

trade cre di tors, i nve stors, suppl i e rs of l ong te rm de bt, e tc.

2 ) Int e rnal analys is : I t is pe rforme d by corporate fi nance and

accounti n g de partme nt and is more de tai le d than exte rnal anal ysi s.

3 ) H o rizo nt al analys is : Thi s anal ysi s compare s fi nanci al state me nts

vi z. profi t and l oss account and bal ance she e t of pre vi ous ye ar wi th
that of curre nt ye ar.

4 ) Ve rt ic al analys is : Ve rti cal anal ysi s conve rts each el e me nt of the

i nformati o n i nto a pe rce nta ge of the total amount of state me nt so as to
e stabl i sh re l ati onshi p w i th othe r compone nt s of the same state me nt.

5 ) Tre nd analys is : Tre nd anal ysi s compare s rati os of di ff e re nt

compone n ts of fi nanci al state me nts re l ate d to di ff e re nt pe ri od w i th that
of the base ye ar.

6 ) Rat io Analys is : I t e stabl i she s the nume ri cal or qua nti tati ve
re l ati onshi p be twe e n 2 i te ms/ vari abl e s of fi nanci al state me nt so that
the stre ng ths and w e akne sse s of a fi rm as al so i ts hi stori cal
pe rforma nce and curre nt fi nanci al posi ti on may be de te rmi ne d.

7 ) Fund s fl o w st at e me n t : Thi s state me nt provi de s a comp re he nsi ve

i de a about the move me nt of fi nance i n a busi ne ss uni t duri n g a
parti cul ar pe ri od of ti me.

8 ) Bre ak - e ve n analys is : Thi s type of anal ysi s re fe rs to the

i nte rpre tati o n of fi nanci al data that re pre se nt ope rati ng acti vi ti e s.

Que s t io n : What are t he us ually f ollo we d rat io cat e g o rie s fo r

b us ines s d at a analys is ? M e nt io n fi nancial rat io s us e d in e ach
cat e g o ry ?

Ans we r : Rati o Anal ysi s is a w i del y use d tool of fi nanci al anal ysi s.
' Rati o' i s re l ati onshi p expre sse d i n mathe mati cal te rms be twe e n 2
i ndi vi dual or gro up of fi gure s conne cte d w i th e ach othe r i n some
l ogi cal manne r; se l e cte d from fi nanci al state me nts of the conce rn.
Ra ti o anal ysi s i s base d on the fact that a si ngl e accounti ng fi gure by
i tse l f mi ght not commu ni cate me ani ngf ul i nformati on, but w he n
expre sse d i n re l ati on to some fi gure , i t may de fi ni tel y provi de ce rtai n
si gni fi cant i nforma ti on, thi s re l ati onshi p be twe e n accounti ng fi gure s i s
know n as fi nanci al rati o. Fi nanci al rati o he l ps to expre ss the
re l ati onshi p be twe e n 2 accounti n g fi gure s i n a manne r that use rs can
draw concl usi ons about the pe rformance , stre ngths and we akne sse s of
a fi rm.

Clas s ifi cat io n o f Rat io s :

I) Acco rd ing t o s o urce : Fi nanci al rati os accordi ng to source from

w hi ch the fi gu re s are obtai ne d may be cl assi fi e d as be l ow :
1 ) Re ve nue rat io s : W he n 2 vari abl e s are take n from re ve nue
state me nt the rati o so compute d is know n as, Re ve nue rati o.
2 ) Balan ce s he e t rat io : W he n 2 vari abl e s are take n from the bal ance
she e t, the rati o so compute d i s know n as, B al ance shee t rati o.
3 ) M ixe d rat io : W he n one vari abl e is take n from the Re ve nue
state me nt and othe r from the B al ance shee t, the rati o so compute d i s
know n as, Mi xe d rati o.

II) Acco rd ing to us ag e : Ge orge Foste r of Stanf ord Uni ve rsi ty gave
se ve n cate gori e s of fi nanci al rati os that exhausti ve l y cove r di ff e re nt
aspe cts of a busi ne ss organi s ati on, the y are :
1 ) C ash posi ti on
2 ) Li qui di ty
3 ) Worki ng C api tal / C ash Fl ow
4 ) C api tal structure
5 ) Profi ta bi l i ty
6 ) De bt Se rvi ce C ove rage
7 ) Turnove r
W hi l e w orki ng on rati o anal ysi s, i t i s i mportant to avoi d
dupl i cati o n of w ork, as same i nforma ti on may be pro vi de d by more than
one rati o, the anal yst has to be se le cti ve i n re spe ct of the use of
fi nanci al rati os. The ope rati ons and fi nanci al posi ti on of a fi rm can be
de scri be d by studyi ng i ts short and l ong te rm li qui di ty posi ti on,
profi tabi l i ty and ope rati onal acti vi ti e s. Thus, rati os may be cl assi fi e d as
fol l ow s :
1 ) Li qui di ty rati os
2 ) C api tal structure / l e ve rage rati os
3 ) Acti vi ty rati os
4 ) Profi ta bi l i ty rati os

Que s t io n : Dis cus s t he vario us rat io s in de t ail ?

Ans we r :
1 ) L iq uid it y rat io s :
'L i qui di ty ' and 'short- te rm sol ve ncy' are use d as synonyms,
me ani ng abi l i ty of the busi ne ss to pay i ts short- te rm l i abi l i tie s.
I nabi l i ty to pay- off short te rm l i abi l i tie s aff e cts the conce rn's cre di bi l i ty
and cre di t rati ng; conti nu ous de faul t i n payme nts l e ads to comme rci al
bankru ptcy that e ve ntual l y l e ads to si ckne ss and di ssol uti on. Short-
te rm l e nde rs and cre di tors of a busi ne ss are i nte re ste d i n know i ng the
conce rn's state of li qui di ty for the i r fi nanci al stake . Tradi ti onal l y
curre nt and qui ck rati os are use d to hi ghl i ght the busi ne ss 'l i qui di ty',
othe rs may be cash rati o, i nte rval me asure rati o and ne t w orki ng
capi tal rati o.

i) Curre nt rat io :

C urre nt rati o = C urre nt Asse ts/ C urre nt Li abi l i ti e s

W he re ,
C urre nt asse ts = I nve ntori e s + Sund ry de btors + C ash and Bank
bal ance s + Re ce i vabl e s/ Accrual s +
Loans and advance s + Di sposabl e Inve stme nts.
C urre nt li abi l i ti e s = C re di tors for goods and se rvi ce s + Short- te rm
Loans + B ank O ve rdraft + C ash
cre di t + O utstan di ng expe nse s + Provi si on for
taxati on + Pro pose d di vi de nd +
Uncl ai me d di vi de nd.

C urre nt rati o i ndi cate s the avai l abi l i ty of curre n t asse ts to

me e t curre nt l i abi l i tie s, hi ghe r the rati o, be tte r i s the cove rage .
Tradi ti on al l y, i t i s call e d 2 : 1 rati o i .e . 2 i s the standard curre nt asse ts
for e ach uni t of curre nt l i abi l i ty. The l e ve l of curre nt rati o vary from
i ndustry to i ndustry de pe ndi ng on the spe ci fi c i ndustr y characte ri sti cs
and al so a fi rm di ff e rs from the i ndustr y rati o due to i ts pol i cy.

ii) Quick rat io :

Q ui ck rati o or aci d te st rati o = Q ui ck Asse ts/ C urre nt or Q ui ck

l i abi l i tie s

W he re ,
Q ui ck asse ts = Sun dry de btors + C ash and B ank bal ance s +
Re ce i vabl e s/ Accrual s +
Loans and advance s + Di sposabl e Inve stme nts i. e .
= C urre nt asse ts - I nve ntori e s.
C urre nt li abi l i ti e s = C re di tors for goods and se rvi ce s + Short- te rm
Loans + B ank O ve rdraft + C ash
cre di t + O utstan di ng expe nse s + Provi si on for
taxati on + Pro pose d di vi de nd +
Uncl ai me d di vi de nd.
Q ui ck li abi l i ti e s = C re di tors for goods and se rvi ce s + Short- te rm Loans
+ O utstandi n g expe nse s
+ Provi si on for taxati on + Pro pose d di vi de nd +
Uncl ai me d di vi de nd i. e.
= C urre nt l i abi l i tie s - B ank ove rdraft - C ash cre di t.

I n the above formul a, i nste ad of total curre nt li abi l i ti e s onl y

those curre n t li abi l i ti e s are take n that are payabl e w i thi n 1 ye ar that
are know n as qui ck l i abi l i tie s. Q ui ck asse ts are al so cal le d l i qui d
asse ts, the y consi sts of cash and onl y 'ne ar cash asse ts'. I nve ntori e s
are de ducte d from curre nt asse ts, as the y are not consi de re d as 'ne ar
cash asse ts', but i n a se l le r's marke t the y are not so consi de re d. J ust
l i ke l ag i n col l e cti on of de btors, the re i s l ag i n conve rsi on of
i nve ntori e s i nto fi ni she d goods and sundry de btors, al so sl ow -movi ng
i nve ntori e s are not ne ar cash asse ts. W hi l e cal cul ati ng the qui ck rati o,
the conse rvati sm conve nti on, qui ck l i abi l i tie s are that porti on of
curre nt li abi l i ti e s that fal l due i mme di ate l y, he nce bank ove rdraft and
cash cre di t are excl ude d.

iii) Cas h rat io :

C ash rati o = (C ash + Marke tabl e se curi ti e s)/ C urre nt l i abi l i tie s

The cash rati o me asure s absol ute l i qui di ty of the busi ne ss avai l abl e
w i th the conce rn.

iv) Int e rval me as ure :

I nte rval me asure = (C urre nt asse ts - I nve ntory)/ Ave rage dai l y
ope rati ng expe nse s

W he re ,
Ave rage dai l y ope rati ng expe nse s = (C ost of goods + Se ll i ng,
admi ni str ati ve and ge ne ral expe nse s -
De pre ci ati on and othe r non- cash
expe ndi tu re )/ no. of days i n a ye ar.

2 ) Cap it al s t ruct ure / L e ve rag e rat io s :

The capi tal structure or l e ve rage rati os are de fi ne d as, those
fi nanci al rati os that me asure l ong te rm stabi l i ty and structu re of the
fi rm and i ndi cate mi x of funds provi de d by ow ne rs and l e nde rs, i n orde r
to assu re l e nde rs of l ong te rm funds as to :
Pe ri odi c payme nt of i nte re st duri ng the pe ri od of the l oan, and
Re pay me nt of the pri nci pal amount on maturi ty.
The y are cl assi fi e d as :

i) Cap it al s t ruct ure rat io s :

C api tal structure rati os provi de an i nsi ght i nto the fi nanci n g
te chni que s use d by a busi ne ss and conse que ntl y focus on the l ong- te rm
sol ve ncy posi ti on. From the bal ance shee t one can ge t absol ute fund
e mpl oye d and i ts source s, but capi tal structu re rati os show re l ati ve
w ei ght of di ff e re nt source s. Funds on li abi l i ti e s si de of bal ance shee t
are cl assi fi e d as 'ow ne r's e qui ti e s' and 'exte rnal e qui tie s' al so call e d
'e qui ty' and 'de bt'. Ow ne r's e qui tie s or e qui ty me ans share hol de r's
funds consi sti ng of e qui ty and pre fe re nce share capi tal and re se rve s
and surpl us. Exte rnal e qui tie s me ans al l outsi de l i abi l i tie s i ncl usi ve
of curre nt l i abi l i tie s and provi si ons, w hi l e de bt i s cl assi fi e d as l ong
te rm borrow e d funds thus, excl udi ng short- te rm l oans, curre n t
l i abi l i tie s and provi si ons. As pe r gui de l i ne s for issue of 'De be ntu re s by
Publ i c Li mi te d C ompany' de bt me ans te rm l oans, de be nture s and bonds
w i th an i ni ti al maturi ty pe ri od of ye ars or more i ncl usi ve of i nte re st
accrue d the re on, al l de fe rre d payme nt li abi l i ti e s, pro pose d de be ntu re
i ssue but excl udi ng short- te rm bank borrow i n gs and advance s,
unse cure d l oans or de posi ts from the publ i c, share h ol de rs and
e mpl oye e s and unse cure d l oans and de posi ts from othe rs. C api tal
structu re rati os use d are :

a) Owne r' s Eq uit y t o t o t al Eq uit y :

O w ne r's Equi ty to total e qui ty rati o = Ow ne r's Equi ty/ Total Equi ty

I t i ndi cate s pro porti on of ow ne rs' fund to total fund i nve ste d
i n busi ne ss. Tradi ti onal be li e f says, hi ghe r the pro porti on of ow ne r's
fund low e r is the de gre e of ri sk.

b ) De b t Eq uit y Rat io :

De bt- e qui ty rati o = De bt/ Equi ty

I t i s the i ndi cator of l e ve rage , show i ng the propo rti on of de bt

fund i n re l ati on to e qui ty. I t is re fe rre d i n capi tal structu re de ci si on as
al so i n the l e gi sl ati ons de al i ng wi th the capi tal structure de ci si ons i .e .
i ssue of share s and de be nture s. Le nde rs are kee n to know thi s rati o as
i t show s re l ati ve w ei ghts of de bt and e qui ty. As pe r tradi ti on al school ,
cost of capi tal fi rstl y de cre ase s due to the hi ghe r dose of le ve rage ,
re ache s mi ni mum and the re afte r i ncre ase s, thus i nfi ni te i ncre ase i n
l e ve rage i .e . de bt- e qui ty rati o i s not possi bl e . How e ve r, accordi ng to
Modi gl i ani - Mi l le r the ory, cost of capi tal and l e ve rage are i nde pe nde nt
of e ach othe r and base d on ce rtai n re stri cti ve assump ti ons, name l y,
- pe rfe ct capi tal marke ts
- homoge ne ous expe ctati ons by the pre se nt and pro spe cti ve i nve stors
- pre se nce of homoge ne ou s ri sk cl ass fi rms
- 1 00 % di vi de nd pay- out
- no tax si tuati on and so on.
Most of the above assump ti ons are unre al i sti c. I t is be l ie ve d
that l e ve rage and cost of capi tal are re l ate d. The re i s no norm for
maxi mu m de bt- e qui ty rati o, l e ndi ng i nsti tuti ons usual l y, se t the i r ow n
norms consi de ri ng the capi tal i nte nsi ty and othe r factors.

ii) Co ve rag e rat io s :

The cove rage rati o me asure s the fi rm's abi l i ty to se rvi ce fi xe d
l i abi l i tie s. The se rati os establ i sh the re l ati onshi p be tw ee n fi xe d cl ai ms
and w hat is usual l y avai l abl e out of w hi ch the se cl ai ms are to be pai d.
The fi xe d cl ai ms consi st of :
I nte re st on l oans
Pre fe re nce di vi de nd
 Amorti sati o n of pri nci pal or re payme nt of the i nstal me nt of l oans
or re de mpti o n of pre fe re nce capi tal on maturi t y. The y are
cl assi fi e d as fol l ow s :

a) De b t s e rvice co ve rag e rat io :

Le nde rs are i nte re ste d i n j udgi ng the fi rm's abi l i ty to pay off
curre nt i nte re st and i nstal me nts and thus the de bt se rvi ce cove rage
rati o.

De bt se rvi ce cove rage rati o = Earni n gs avai l abl e for de bt se rvi ce/
(I nte re st + I nstal me nts)

W he re ,
Earni n g avai l abl e for de bt se rvi ce = Ne t profi t + N on- cash ope rati ng
expe nse s li ke de pre ci ati on
and othe r amorti sati o ns + N on-
ope rati ng adj ust me nts as l oss on
sal e of fi xe d asse ts + I nte re st on
de bt fund.

b ) Int e re s t co ve rag e rat io :

I t i s al so know n as "ti me s i nte re st e arne d rati o" and
i ndi cate s the fi rm's abi l i ty to mee t i nte re st obl i gati ons and othe r fi xe d
charge s.

I nte re st cove rage rati o = EBI T/ I nte re st

W he re ,
EB I T = Earni ngs B e fore I nte re st and Tax
EB I T i s use d i n the nume rator as the abi l i ty to pay i nte re st i s
not aff e cte d by tax burde n as i nte re st on de bt funds i s a de ducti bl e
expe nse . Thi s rati o i ndi cate s the exte nt to w hi ch e arni ngs may fal l
w i thout causi ng any di ffi cul t to the fi rm re gardi ng the payme nt of
i nte re st charge s. A hi gh i nte re st cove rage rati o me ans that an
e nte rpri se can e asil y me e t i ts i nte re st obl i gati ons e ve n i f EB I T suff e r a
consi de rabl e de cl i ne , w hi l e a l ow e r rati o i ndi cate s exce ssi ve use of
de bt or i ne ffi cie nt ope rati ons.

c) Pre f e re nce d ivid e nd co ve rag e rat io :

I t me asure s the fi rm's abi l i ty to pay pre fe re nce di vi de nd at the state d
rate .

Pre fe re nce di vi de nd cove rage rati o = EAT/ Pre fe re nce di vi de nd li abi l i ty

W he re ,
EAT = Earni n gs afte r tax
EAT i s consi de re d as unl i ke de bt on w hi ch i nte re st i s a charge
on the fi rm's profi t, pre fe re nce di vi de nd i s an app ropri a ti on of profi t.
The rati o i ndi cate s margi n of safe ty avai l abl e to pre fe re nce
share hol de rs. A hi ghe r rati o i s de si rabl e fro m pre fe re nce share hol de rs
poi nt of vi e w.
iii) Cap it al Ge aring rat io :

C api tal ge ari ng rati o = (Pre fe re nce Sha re C api tal + De be nture s + Long
te rm l oan)/
(Equi ty share capi tal + Re se rve s & Surpl us - Losse s)

I t i s use d i n addi ti on to de bt e qui ty rati o to show the

pro porti o n of fi xe d i nte re st/ di vi de nd be ari ng capi tal to funds bel ongi n g
to e qui ty share hol de rs.

For the j udgi ng of the l ong- te rm sol ve ncy posi ti on, i n addi ti on
to de bt- e qui ty and capi tal ge ari ng rati os, the fol l owi ng are use d :

a) Fix e d Ass e ts / L o ng t e rm f und : Fi xe d asse ts and core w orki ng

capi tal are expe cte d to be fi nance d by l ong te rm fund. I n vari ous
i ndustri e s the propo rti on of fi xe d and curre nt asse ts are di ff e re nt, thus
the re can be no uni form stand ard of thi s rati o, but i t shoul d be l e ss
than 1 . I f i t is more than 1, i t me ans short- te rm fund has be e n use d to
fi nance fi xe d asse ts, ofte n bi g compani e s re sort to such practi ce duri ng
expansi on. Thi s may be a te mporar y arrange me nt but not a l ong- te rm
re me dy.

b ) Pro p rie t ary rat io :

Pro pri e tary rati o = Propri e tary fund/ Total asse ts

W he re ,
Pro pri e tary fund = Equi ty share capi tal + Pre fe re nce share capi tal +
Re se rve s & surpl us - Fi ci ti ti ous
asse ts
Total asse ts = Al l asse ts, but excl ude s fi cti ti ous asse ts and l osse s.
I t i s possi bl e to re duce e qui ty stake by l owe ri ng li qui di ty rati o
i .e curre nt rati o,
Ex amp le : W he n curre n t and de bt- e qui ty rati os are both 2 : 1 e ach,
and the pro porti on of fi xe d and curre nt asse ts i s
5 : 1 Equi ty/ tot al asse ts = 3 1. 67 % but i f the curre nt rati o i s re duce d to
1 .5 : 1 e qui ty/ total asse ts = 31 .1 1 %.

3 ) Act ivit y rat io s :

The acti vi ty rati os al so know n as turnove r or pe rformance
rati os are e mpl oye d to e val uate the e ffi ci e ncy wi th w hi ch the fi rm
mana ge s and uti l i se s i ts asse ts. The se rati os usual l y i ndi cate the
fre que ncy of sale s w i th re spe ct to i ts asse ts, w hi ch may be capi tal
asse ts or w orki ng capi tal or ave rage i nve ntory. The se are cal cul ate d
w i th re fe re nce to sal e s/ cost of goods sol d and are expre sse d i n te rms of
rate or ti me s. The y are as fol l ow s :
i) Cap it al t urno ve r rat io :

C api tal turnove r rati o = Sal e s/C api tal e mpl oye d
 I t i ndi cate s the fi rm's abi l i ty of ge ne rati ng sal e s pe r rupe e
of l ong te rm i nve stme nt, the hi ghe r the rati o, more e ffi ci e nt i s the
uti l i sati on of the ow ne r's and l ong- te rm cre di tors' funds.

ii) Fix e d Ass e ts t urno ve r rat io :

Fi xe d Asse ts turnove r rati o = Sal e s/ C api tal asse ts

A hi gh fi xe d asse ts turnove r rati o i ndi cate s effi cie nt

uti l i sati on of fi xe d asse ts i n ge ne rati on of sal e s. A fi rm w hose pl ant and
machi ne ry are ol d may show a hi ghe r fi xe d asse ts turnove r rati o than
the fi rm w ho purch ase d the m re ce ntl y.

iii) Wo rk ing cap it al t urno ve r rat io :

Worki ng capi tal turno ve r = Sal e s/ Worki ng C api tal

I t i s furthe r di vi de d as bel ow :
a) Inve nt o ry t urno ve r rat io :

I nve ntory turnove r rati o = Sal e s/ Ave rage i nve ntory

W he re ,
Ave rage i nve ntory = (O pe ni ng Stock + C l osi ng stock)/2
I t may al so be cal cul ate d wi th re fe re nce to cost of sal e s i nste ad of
sal e s, as :

I nve ntory turnove r rati o = C ost of sale s/ Ave rage i nve ntory

For i nve ntory of raw mate ri al ,

I nve ntory turnove r rati o = Raw mate ri al consume d/ Ave ra ge raw

mate ri al stock.

Thi s rati o i ndi cate s the spee d of i nve ntory usage . A hi gh

rati o is good from li qui di ty poi nt of vie w and vi ce ve rsa. A l ow rati o
i ndi cate s that i nve ntory i s not use d/ sol d or i s l ost and stays i n a shel f
or i n the w are house for a l ong ti me .

b ) De b to rs t urno ve r rat io :
W he n a fi rm se l l s goods on cre di t, the re al i sati on of sal e s
re ve nue i s de l aye d and re cei vabl e are cre ate d. C ash i s re al i se d from
the se re cei vabl e s l ate r on, the spe e d wi th w hi ch i t is re al i se d aff e cts
the fi rm's l i qui di ty posi ti on. De btors turnove r rati o throw s l i ght on the
col le cti on and cre di t pol i ci e s of the fi rm.

De btors turnove r rati o = Sal e s or C re di t sale s/ Ave rage accounts

re ce i vabl e
 As account re cei vabl e pe rtai ns to cre di t sale s onl y, i t i s
ofte n re comme nde d to compu te de btor's turnove r wi th re fe re nce to
cre di t sale s rathe r than total sal e s.

Ave rage col l e cti on pe ri od = Ave rage accounts re ce i vabl e s/ ave rage dai l y
cre di t sale s

W he re ,
ave rage dai l y cre di t sal e s = C re di t sal e s/3 65
The above rati os provi de a uni que gui de for de te rmi ni ng the
fi rm's cre di t pol i cy.

c) Cre d it o rs t urno ve r rat io :

I t i s cal cul ate d on same l i ne as de btors turnove r rati o and
show s the ve l oci ty of de bt payme nt by the fi rm,

C re di tors turnove r rati o = C re di t purch ase s or Annual ne t cre di t

purch ase s/ Ave rage accounts payabl e

A l ow rati o re fl e cts l i be ral cre di t te rms grante d by suppl i e rs,

w hi le a hi gh rati o re fl e cts rapi d se ttle me nt of accounts.

Ave rage payme nt pe ri od = Ave rage accounts payabl e / ave rage dai l y
cre di t purc hase s
W he re ,
ave rage dai l y cre di t purc hase s = cre di t purc hase s/ 3 65
The fi rm can compare w hat cre di t pe ri od i t re ce i ve s from the
suppl i e rs and w hat i t off e rs to the custome rs. I t can al so compare the
ave rage cre di t pe ri od off e re d to the custome rs i n the i ndustry to w hi ch
i t be l ongs.

4 ) Pro fi t ab ilit y rat io :

The profi t abi l i ty rati os me asure profi t abi l i ty or the ope rati onal
e ffi ci e ncy of the fi rm re fl e cti ng the fi nal re sul ts of busi ne ss ope rati ons.
The re sul ts of the fi rm may be e val uate d i n te rms of i ts e arni ngs wi th
re fe re nce to a gi ve n le ve l of asse ts or sal e s or ow ne rs i nte re st, e tc.
Thus, the profi ta bi l i ty rati os are bro adl y cl assi fi e d i n fol l owi ng
cate gori e s :
i) Pro fi t ab ilit y rat io s are req uire d f o r analys is f ro m o wne rs po int
o f vie w :

a) Re t urn o n e q uit y (ROE) : I t me asure s the profi ta bi l i ty of e qui ty

funds i nve ste d i n the fi rm and re ve al s how profi ta bl y the ow ne r's funds
are uti l i se d by the busi ne ss.

RO E = Profi t afte r taxe s/ N e t w orth

b ) Earni ng s pe r share ( EPS) : The profi t abi l i ty of a fi rm fro m vie w
poi nt of ordi nary share hol de rs can be me asure d i n te rms of numbe r of
e qui ty share s know n as e arni ngs pe r share .

EPS = Ne t profi t avai l abl e to e qui ty hol de rs/ no. of ordi nary share s
outsta ndi n g

c) Divid e nd pe r share : EPS as above re fl e cts the profi tabi l i ty of a

fi rm pe r share , i t doe s not re fl e ct how much profi t i s pai d as di vi de nd
and how much i s re tai ne d by the busi ne ss. Di vi de nd pe r sha re rati o
i ndi cate s the amou nt of profi t di stri bute d to share hol de rs pe r share .

Di vi de nd pe r sha re = Total profi ts di stri bute d to e qui ty sha re

hol de rs/ N umbe r of e qui ty share s

d ) Price Earning rat io ( P. E. Rat io ) : The pri ce e arni ng rati o

i ndi cate s the expe ctati on of e qui ty i nve stors about the e arni ngs of the
fi rm and re l ate s to marke t pri ce and i s ge ne ral l y take n as a summary
me asure of grow t h pote nti al of an i nve stme nt, ri sk characte ri sti cs,
share hol de rs orie ntati on, corporate i mage and de gre e of l i qui di ty.

P. E. Rati o = Marke t pri ce pe r share / EPS

ii) Pro fi t ab ilit y rat io s b as ed o n ass e ts / inve s t me nts :

a) Re t urn o n cap it al e mp lo yed / Ret urn o n Inves t me nt ( ROI) :

RO I = Re turn/ C api t al e mpl oye d * 1 00

W he re ,
Re turn = N e t profi t + / - N on- tradi ng adj ust me nts excl udi ng accrual
adj ustme n ts for amorti sati on of
pre l i mi nary expe nse s, goodw i l l , etc. + I nte re st on l ong te rm
de bts + Pro vi si on for tax -
I nte re st/ Di vi de nd from non- trade i nve stme nts.
C api tal e mpl oye d = Equi ty share capi tal + Re se rve s & Surpl us +
Pre fe re nce share capi tal + De be ntu re s
and othe r l ong te rm l oan - Mi sce ll ane ous
expe ndi tu re and l osse s - N on-trade
i nve stme nts.

I t can be furthe r bi furcate d as :

RO I = (Re turn/ sal e s) * (Sal e s /C api tal e mpl oye d) * 10 0

W he re ,
Re turn/ sal e s * 10 0 = Profi ta bi l i ty rati o
Sal e s / C api tal e mpl oye d = C api tal turnove r rati o
Thus,
RO I = Profi ta bi l i ty rati o * C api tal turnove r rati o
 RO I can be i mprove d by i mprovi n g ope rati ng profi t or capi tal turno ve r
or both.

c) Re t urn o n as se t s (ROA) :
The profi t abi l i ty rati o i s me asure d i n te rms of re l ati onshi p be twe e n ne t
profi ts and asse ts e mpl oye d to e arn that profi t. It me asure s the fi rm's
profi tabi l i ty i n te rms of asse ts e mpl oye d i n the fi rm.

ROA = N e t profi t afte r taxe s/ Ave ra ge total asse ts or

= Ne t profi t afte r taxe s/ Ave rage tangi bl e asse ts or
= Ne t profi t afte r taxe s/ Ave rage fi xe d asse ts.

The cause of any i ncre ase or de cre ase i n ROI can be trace d out onl y
afte r a compl e te anal ysi s throu gh expe nse s and turnove r rati os.

ROI = Return/Capital employed * 100

Profitability ratios Capital Turnover ratio (Sales/Capital employed)

(Return/Sales * 100)

i) Fixed
i) Material expenses/Sales * Fixed assets Working capital turnover ratio
consumed/sales * 100 100 turnover ratio (sales/working capital)
(sales/fixed
ii) Wages/Sales * 100 assets)
iii) Manufacturing ii) Variable
expenses/sales *100 expenses/Sales *
100 Turnover of
iv) Administration individual assets
expenses/sales * 100
Debtor' Creditor
Inventory
s 's
v) Selling & turnover
turnov turnover
Distribution ratio
er ratio ratio
expenses/Sales * 100

iii) Pro fi t ab ilit y rat io s b as e d o n s ale s of t he fi rm :

a) Gro ss p ro fi t rat io :

Gross profi t rati o = Gross profi t/ sal e s * 10 0

I t i s use d to compare de partme nt al or prod uct profi t abi l i ty. I f costs are
cl assi fi e d sui tabl y i nto fi xe d and vari abl e el e me nts, the n i nste ad of
gross profi t rati o one may fi nd P/ V rati o.

P/ V rati o = (Sal e s - Vari abl e cost)/ Sal e s * 10 0

Fi xe d cost re mai ni n g same , hi ghe r the P/ V rati o l ow e r i s the bre ak eve n

poi nt (B. E. P. ) O pe rati ng profi t rati o i s cal cul ate d to e val uate ope rati ng
pe rforma nce of busi ne ss.

b ) Op e rat ing p ro fi t rat io :

O pe rati ng profi t rati o = O pe rati ng profi t/ S al e s * 1 00

W he re ,
O pe rati ng profi t = Sal e s - C ost of sale s

c) N e t p ro fi t rat io : I t me asure s the ove ral l profi tabi l i ty of the

busi ne ss.

N e t profi t rati o = Ne t profi t/ sal e s * 10 0

Que s t io n : Are fi nancial rat io s re le vant in fi nancial de cis io n

mak ing ?

Ans we r : A popul ar te chni que of anal ysi ng the pe rformance of a

busi ne ss conce rn i s that of fi nanci al rati o anal ysi s, i t, as a tool of
fi nanci al manage me nt is of cruci al si gni fi cance . Its i mportance l ie s i n
the fact that i t pre se nts facts on a comparati ve basi s and e nabl e s
draw i ng of i nfe re nce s as re gards a fi rm's pe rformance . I t i s re le vant i n
asse ssi ng the fi rm's pe rformance i n the bel ow me nti one d aspe cts :

I) Financi al rat io s f o r e valuat io n of pe rf o rmance :

L iq uid it y po s it io n : Ra ti o anal ysi s assi sts i n draw i ng

concl usi ons as re gards the fi rm's li qui di ty posi ti on. I t w oul d be
sati sfactory if the fi rm is abl e to mee t i ts curre nt obl i gati ons
w he n the y be come due . A fi rm can be sai d to have the abi l i ty to
me e t i ts short- te rm li abi l i ti e s i f i t has suffi ci e nt l i qui di ty to pay
i nte re st on i ts short- maturi ng de bt, usual l y wi thi n a ye ar as al so
the pri nci pal . Thi s abi l i ty i s re fl e cte d i n the l i qui di ty rati os of the
fi rm and li qui di ty rati os are use ful i n cre di t anal ysi s by banks and
othe r suppl i e rs of short- te rm l oans.

L o ng - t e rm so lve ncy : Rati o anal ysi s i s e qual l y he l pful for

asse ssi ng a fi rm's l ong- te rm fi nanci al vi abi l i ty. Thi s aspe ct of the
 fi nanci al posi ti on of a borrow e r i s of conce rn to the l ong- te rm
cre di tors, se curi ty anal ysts and the pre se nt and pote nti al ow ne rs
of a busi ne ss. The l ong- te rm sol ve ncy is me asure d by the
l e ve rage / capi tal struc ture and profi t abi l i ty rati os focusi ng on
e arni ng pow e r and ope rati ng effi cie ncy and rati o anal ysi s re ve al s
the stre ng th and w e akne sse s of a fi rm i n re spe ct the re to. The
l e ve rage rati os, for exampl e , i ndi cate s w he the r a fi rm has a
re asona bl e pro porti o n of vari ous source s of fi nance or w he the r
he avi l y l oade d w i th de bt i n w hi ch case i ts sol ve ncy i s expose d to
se ri ous strai n. I n the same manne r, vari ous profi tabi l i ty rati os
re ve al w he the r or not the fi rm is abl e to off e r ade qua te re turn to
i ts ow ne rs consi ste nt wi th the ri sk i nvol ve d.

Op e rat ing e ffi cie ncy : Rati o anal ysi s throw s li ght on the de gre e
of e ffi ci e ncy i n the manage me nt and uti li sati on of i ts asse ts.
Vari ous acti vi ty rati os me asure thi s ki nd of ope rati onal e ffi ci e ncy,
a fi rm's sol ve ncy i s, i n the ul ti mate anal ysi s, de pe nde nt on the
sal e s re ve nue s ge ne rate d by the use of i ts asse ts - total as w el l
as i ts compone n ts.

Ove r- all- p ro fi t ab ilit y : Unl i ke outsi de parti e s, that are

i nte re ste d i n one aspe ct of the fi nanci al posi ti on of a fi rm, the
mana ge me nt i s constantl y conce rne d about the ove rall
profi tabi l i ty of the e nte rpri se i. e. the y are conce rne d about the
fi rm's abi l i ty to mee t i ts short- te rm and l ong- te rm obl i gati ons to
i ts cre di tors, to e nsure re asona bl e re turn to i ts ow ne rs and
se cure opti mu m uti l i sati on of the fi rm's asse ts. I t i s possi bl e if an
i nte grate d vie w i s take n and al l the rati os are consi de re d
toge the r.

Int e r- fi rm co mp aris o n : Rati o anal ysi s not onl y throw s li ght on

the fi rm's fi nanci al posi ti on but al so se rve s as a ste ppi ng stone
to re me di al me asure s. I t i s made possi bl e by i nte r- fi rm
compari so n/ comp ari son w i th i ndustry ave rage . It shoul d be
re asona bl y expe cte d that the fi rm's pe rformance is i n broa d
conformi t y wi th that of the i ndustry to w hi ch i t be l ongs. An i nte r-
fi rm compari son de monstra te s the re l ati ve posi ti on vi s--vi s i ts
compe ti tors. I f the re sul ts are at vari ance ei the r wi th the i ndustry
ave rage or w i th that of the compe ti tors, the fi rm can se e k to
i de nti fy the proba bl e re asons and i n i ts l i ght, take re me di al
me asure s. Rati os not onl y pe rform post- morte m of ope rati ons,
but al so se rve s as ba rome te r for future , the y have pre di ctory
val ue and are he l pful i n fore casti ng and pl anni n g future busi ne ss
acti vi ti e s and hel ps i n budge ti ng.

II) Financ ial rat io s fo r b ud g e t ing : I n thi s fi el d rati os are abl e to

provi de a gre at de al of assi stance , budge t i s onl y an e sti mate of futu re
acti vi ty base d on past expe ri e nce , i n the maki ng of w hi ch the
re l ati onshi p be twe e n di ff e re nt sphe re s of acti vi ti e s are i nval uabl e . I t is
usual l y possi bl e to e sti mate budge te d fi gu re s usi ng fi nanci al rati os.
Ra ti os al so can be made use of for me asuri ng actual pe rformance w i th
bud ge te d fi gure s and i ndi cate di re cti ons i n w hi ch adj ustme nts shoul d
be made e i the r i n the budge t or i n pe rformance to bri ng the m cl ose r to
e ach othe r.

Que s t io n : What are t he limit at io ns of fi nancial rat io s ?

Ans we r : Li mi tati ons of fi nanci al rati os are as fol l ow s :

i) Dive rs ifi e d p rod uct line s : Many busi ne sse s ope rate a l arge
num be r of di vi si ons i n qui te di ff e re nt i ndustri e s. I n such case s rati os
cal cul ate d on the basi s of agg re ga te data cannot be use d for i nte r-fi rm
compari so ns.

ii) Financ ial d at a are b ad ly d is to rt e d by infl at io n : Hi stori cal cost

val ue s may be substanti al l y di ff e re nt from true val ue s, such di storti ons
i n fi nanci al data are al so carri e d i n fi nanci al rati os.

iii) Se as o nal f act o rs may als o infl ue nce fi nanci al d at a

iv) To g ive g oo d shap e t o t he fi nanci al rat io s us ed po p ularly :

The busi ne ss may make some ye ar- e nd adj ustme n ts, such w i ndow -
dre ssi ng can change the characte r of fi nanci al rati os that w oul d be
di ff e re nt had the re bee n no change .

v) Di ff e re nce s i n accounti n g pol i ci e s and accounti ng pe ri od make the

accounti n g data of 2 fi rms non- compara bl e as al so the accounti ng
rati os.

vi ) The re i s no standard se t of rati os agai nst w hi ch a fi rm's rati os may

be compa re d, some ti me s, i f a fi rm de ci de s to be above ave rage the n,
i ndustry ave rage be come s a l ow standa rd. O n the othe r hand, for a
be l ow ave rage fi rm, i ndustry ave rage s be come too hi gh as stand ard s to
achi e ve .

vi i ) It i s di ffi cul t to ge ne ral i se w he the r a parti cul ar rati o i s good or bad,

for i nstance , a l ow curre nt rati o may be 'bad ' from the vi ew poi nt of l ow
l i qui di ty, w hil e a hi gh curre n t rati o may be 'ba d' as i t may re sul t from
i ne ffi ci e nt w orki ng capi tal manage me n t.

vi i i ) Fi nanci al rati os are i nte r-re l ate d and not i nde pe nde nt, w he n
vi ew e d i n i sol ati on one rati o may hi ghl i ght effi cie ncy but, as a se t of
rati os i t may spe ak di ff e re ntl y. Such i nte rde pe nde nce among the rati os
can be take n care of throug h mul ti vari ate anal ysi s. Fi nanci al rati os
provi de cl ue s but not concl usi ons. The se are tool s i n the hands of
expe rts as the re is no standard re ady- made i nte rpre tati on of fi nanci al
rati os.
Que s t io n: what are t he vario us rat io s b as e d on cap it al marke t
inf o rmat io n?

Ans we r : fre que ntl y sha re pri ce s data are punc he d wi th accounti ng
data to ge ne rate ne w se t of i nformati o n, the se are :

i) Price e arning rat io :

Pri ce e arni ng rati o (PE rati o) = ave rage or cl osi ng share pri ce s/ EPS

I t i ndi cate s the payback pe ri od to i nve stors or pros pe cti ve i nve stors.

ii) Yie ld :

Yi e l d = di vi de nd/ ave rage or cl osi ng share pri ce * 10 0

I t i ndi cate s re turn on i nve stme nt, w hi ch may be on ave rage

or cl osi ng i nve stme nt. Di vi de nd % i ndi cate s re turn on pai d- up val ue of
share s, but, yie l d % i s the i ndi cator of true re turn i n w hi ch share
capi tal i s take n at i ts marke t val ue.

iii) M arke t value / b o ok value fo r s hare :

Marke t val ue for share / book val ue pe r share = ave rage share pri ce/ (ne t
w orth/ numbe r of e qui ty share s)
or

= cl osi ng share pri ce / (ne t

w orth/ num be r of e qui ty share s)

I t i ndi cate s marke t re sponse of share hol de rs' i nve stme nt.
Hi ghe r the rati o be tte r i s the share hol de rs posi ti on i n te rms of re turn
and capi tal gai ns.

Que s t io n: what are t he rat io s co mp ut ed f o r inve st me nt

analys t s ?

Ans we r : Inve stme nt anal ysi s are publ i she d we ekl y i n e conomi c
ne w spape rs, some rati os are use d by anal ysi s to re port pe rforma nce of
se le cte d compani e s. Le t us di scuss the i ssue s hi ghl i ghte d by Economi c
Ti me s unde r the capti on ' pe rformance i ndi cators' :

i ) B ook val ue pe r share = (e qui ty capi tal + re se rve s and surpl us

excl udi ng re val uati o n re se rve s)/ num be r

of e qui ty share s

i i ) EPS = (ne t profi t - pre fe re nce di vi de nd)/ num be r of e qui ty share s

i i i ) di vi de nd %

i v) yie l d % = e qui ty di vi de nd/ marke t pri ce * 10 0

v) payout rati o % = di vi de nd i ncl udi ng pre fe re nce di vi de nd/ profi t afte r

tax * 1 00

vi ) gross margi n/ sal e s (%)

w he re ,
gross margi n = profi t be fore de pre ci ati on but afte r i nte re st and be fore
tax

vi i ) gross margi n/ ca pi tal e mpl oye d (%)

w he re ,
gross margi n = profi t be fore de pre ci ati on but afte r i nte re st and be fore
tax
capi tal e mpl oye d = fi xe d asse ts + capi tal w ork-i n- prog re ss +
i nve stme nts + curre n t asse ts
i .e . aggre g ate of fi xe d asse ts, capi tal w ork-i n-pro gre ss, i nve stme nt and
curre nt asse ts but excl udi ng accumul ate d de fi ci t.

vi i i ) PE rati o = pri ce /e arni n gs

i x) curre nt rati o = curre nt asse ts/ curre n t li abi l i ti e s

Que s t io n : ho w d o es t he cas h fl o w analys is he lp a b us ines s e nt it y

?

Ans we r : cash fl ow anal ysi s i s an i mportant tool wi th the fi nance

mana ge r for asce rtai ni ng the change s i n cash i n hand and bank
bal ance s as from one date to anothe r, duri ng the accounti ng ye ar and
al so be tw ee n tw o accounti ng pe ri ods. I t show s i nfl ow s and outfl ow s of
cash i. e . source s and appl i c ati ons of cash duri ng a parti cul ar pe ri od.
The proce du re for pre par ati on of cash fl ow state me nt, i ts obj e cti ve s
and re qui re me nts are cove re d i n AS- 3. It i s an i mporta nt tool for short-
te rm anal ysi s, li ke othe r fi nanci al state me nts, i t i s anal yse d to re ve al
si gni fi cant re l ati onshi ps. Tw o maj or are as, that anal ysts exami ne w hi l e
studyi n g a cash fl ow state me nt are di scusse d as be l ow:

1 ) cas h ge ne rat ing e ffi cie ncy :

i t i s the abi l i ty of a company to ge ne rate cash from i ts
curre nt or conti nui ng ope rati ons. Fol l owi ng rati os are use d for the
purpo se .

i) cas h fl o w yie ld :
cash fl ow yi e l d = ne t cash fl ow fro m ope rati ng acti vi ti e s/ ne t i ncome

ii) cas h fl o w to s ales :

 cash fl ow to sale s = ne t cash fl ow from ope rati ng acti vi ti e s/ ne t sal e s

iii) cas h fl o ws to ass e t s :

cash fl ow to asse ts = ne t cash fl ow from ope rati ng acti vi tie s/ ave rage
total asse ts

2 ) Fre e cas h fl o w :
stri ctl y cash fl ow is the amount of cash that re mai ns afte r
de ducti n g funds that the company has to commi t to conti nue ope rati ng
at i ts pl anne d l e ve l . Such commi tme nt has to cove r curre n t or
conti nui n g ope rati ons, i nte re st, i ncome tax, di vi de nd, ne t capi tal
expe ndi tu re s and so on. If the cash fl ow i s posi ti ve , i t me ans the
compa ny has me t al l i ts pl anne d commi tme nt and has cash avai l abl e to
re duce de bt or expand. A ne gati ve fre e cash fl ow me ans the company
w i ll have to se ll i nve stme nts, borrow mone y or i ssue stock i n short-
te rm to conti nue at i ts pl anne d l e ve l .

3 ) o t he rs :
be si de s me asuri ng cash effi cie ncy and fre e cash fl ow , wi th
the he l p of cash fl ow state me nt, the fi nanci al anal ysts al so cal cul ate s a
num be r of rati os base d on cash fi gure s rathe r than on e arni ng fi gure s.
Some of w hi ch are as be l ow:

i ) pri ce pe r share / fre e cash fl ow pe r share

i i ) ope rati ng cash fl ow / ope rati ng profi t

i t show s that accrual adj ustme nts are not havi ng se ve re eff e ct on
re porte d profi ts.

i i i ) se l f-fi nanci n g i nve stme nt rati o = i nte rnal fundi ng/ ne t i nve stme nt
acti vi ti e s
i t i ndi cate s how much of the funds ge ne rate d by the busi ne ss are re -
i nve ste d i n asse ts.

Que s t io n : what d o yo u me an by f unds fl o w analys is ?

Ans we r : Funds fl ow anal ysi s i s an i mporta nt l ong- te rm anal ysi s tool i n

the hands of fi nance manage r for asce rtai ni ng change s i n fi nanci al
posi ti on of fi rm be twe e n tw o accounti ng pe ri ods. It anal yse s re asons
for chan ge s i n fi nanci al posi ti on be twe e n tw o bal ance she e ts and show s
the i nfl ow and outfl ow of funds i. e . source s and appl i cati on of funds
duri ng a parti cul ar pe ri od.
I t provi de s i nformati o n that bal ance she e t and profi t and l oss account
fai l to provi de i .e . change s i n fi nanci al posi ti on of an ente rpri se , w hi ch
i s of gre at he l p to the use rs of fi nanci al i nformati on. I t is of gre at he l p
to mana ge me nt, share hol de rs, cre di tors, broke rs, etc. as i t hel ps i n
answ e ri ng the fol l ow i ng que sti ons:
- w he re have the profi ts gone ?
- w hy the re i s an i mbal ance exi sti ng be tw ee n li qui di ty and profi t abi l i ty
posi ti on of the e nte rpri se ?
- w hy i s the conce rn fi nanci al l y soli d i nspi te of l osse s ?

The proj e cte d funds fl ow state me nt can be pre pare d for

bud ge tary control and capi tal expe ndi ture control i n the
organi sa ti on. A proj e cte d funds fl ow state me nt may be pre pa re d
and re sou rce s pro pe rl y all ocate d afte r an anal ysi s of pre se nt
state of aff ai rs.
The opti mum uti l i sati on of avai l abl e funds is e sse nti al for ove rall
grow t h of the e nte rpri se. The funds fl ow state me nt pre pare d i n
advance gi ve s a cle ar- cut di re cti on to the manage me nt i n thi s
re gard.
I t i s al so use ful to manage me nt for j udgi n g the fi nanci al
ope rati ng pe rforma nce of the compa ny and i ndi cate s w orki ng
capi tal posi ti on that he l ps the mana ge me nt i n taki ng pol i cy
de ci si ons re gardi ng di vi de nd, e tc. I t he l ps the manage me nt to
te st w he the r the w orki ng capi tal is e ff e cti vel y use d or not and
that w orki ng capi tal l eve l i s ade quate or i nade quate for the
re qui re me nts of busi ne ss.
I t hel ps i nve stors to de ci de w he the r compa ny has funds manage d
pro pe rl y, i ndi cate s cre di tw orthi ne ss of a company that he l ps
l e nde rs to de ci de w he the r to l e nd mone y to the company or not.
I t hel ps manage me nt to make de ci si ons and de ci de about the
fi nanci n g pol i cie s and capi tal expe ndi tu re progr amme for futu re .

CHAPTER FOUR

CAPITAL BUDGETING

Question : Explain the meaning of capital budgeting ?

Answer : The term capital budgeting means planning for capital assets. Capital
budgeting decision means the decision as to whether or not to invest in long-
term projects such as setting up of a factory or installing a machinery or creating
additional capacities to manufacture a part which at present may be purchased
from outside and so on. It includes the financial analysis of the various
proposals regarding capital expenditure to evaluate their impact on the financial
condition of the company for the purpose to choose the best out of the various
alternatives. The finance manager has various tools and techniques by means of
which he assists the management in taking a proper capital budgeting decision.
Capital budgeting decision is thus, evaluation of expenditure decisions that
involve current outlays but are likely to produce benefits over a period of time
longer than one year. The benefit that arises from capital budgeting decision
may be either in the form of increased revenues or reduced costs. Such decision
requires evaluation of the proposed project to forecast likely or expected return
from the project and determine whether return from the project is adequate. Also
as business is a part of society, it is its moral responsibility to undertake only
those projects that are socially desirable. Capital budgeting decision is an
important, crucial and critical business decision due to :

1) substantial expenditure :
capital budgeting decision involves the investment of substantial amount of
funds and is thus it is necessary for a firm to make such decision after a
thoughtful consideration, so as to result in profitable use of scarce resources.
Hasty and incorrect decisions would not only result in huge losses but would
also account for failure of the firm.

2) long time period :

capital budgeting decision has its effect over a long period of time, they affect
the future benefits and also the firm and influence the rate and direction of
growth of the firm.

3) irreversibility :
most of such decisions are irreversible, once taken, the firm may not been in a
position to reverse its impact. This may be due to the reason, that it is difficult to
find a buyer for second-hand capital items.

4) complex decision :
capital investment decision involves an assessment of future events, which in
fact are difficult to predict, further, it is difficult to estimate in quantitative terms
all benefits or costs relating to a particular investment decision.

Question: discuss the various types of capital investment decisions?

Answer : there are various ways to classify capital budgeting decisions,

generally they are
classified as :

1) on the basis of the firm's existence :

capital budgeting decisions are taken by both newly incorporated and
existing firms. New firms may require to take decision in respect of selection of
plant to be installed, while existing firms may require to take decision to meet
the requirements of new environment or to face challenges of competition. These
decisions may be classified into:

i) replacement and modernisation decisions : replacement and modernisation

decisions aims to improve operating efficiency and reduce costs. Usually, plants
require replacement due to they been economically dead i.e. no more economic
life left or on they becoming technologically outdated. The former decision is of
replacement and latter one of modernisation , however, both these decisions are
cost reduction decisions.

ii) Expansion decision : existing successful firms may experience growth in

demand of the product and may experience shortage or delay in delivery due to
inadequate production facilities and thus, would consider proposals to add
capacity to existing product lines.

iii) Diversification decisions : these decisions require evaluation proposals to

diversify into new product lines, new markets, etc. to reduce risk of failure by
dealing in different products or operating in several markets. expansion and
diversification decisions are revenue expansion decisions.

2) on the basis of decision situation :

i) mutually exclusive decisions : decisions are said to be mutually exclusive

when two or more alternative proposals are such that acceptance of one would
exclude the acceptance of the other.

ii) Accept-Reject decisions : the accept-eject decisions occurs when proposals

are independent and do not compete with each other. The firm may accept or
reject a proposal on the basis of a minimum return on the required investment.
All those proposals which have a higher return than certain desired rate of return
are accepted and rest rejected.

iii) Contigent decisions :

contigent decisions are dependable proposals, investment in one requires
investment in another.

Question: what are the various projects evaluation techniques explain them
in detail ?'

Answer : At each point of time, business manager, has to evaluate a number of

proposals as regards various projects where he can invest money. He compares
and evaluates projects and decides which one to take up and which to reject.
Apart from financial considerations, there are many other factors considered
while taking a capital budgeting decision. At times a project may be undertaken
only to establish foothold in the market or for better welfare of the society as a
whole or of the business or for increasing the safety and security of workers, or
due to requirements of law or because of emotional reasons for instance, many
industrial sector projects are taken up at home towns even if better locations are
available. The major consideration in taking a capital budgeting decision is to
evaluate its returns as compared to its investments. Evaluation of capital
budgeting proposals have two dimensions i.e. profitability and risk, which are
directly related. Higher the profitability, higher would be the risk and vice versa.
Thus, the finance manager has to strike a balance between profitability and risk.
Following are some of the techniques used to evaluate financial aspects of a
project :

1) payback period :
it is one of the simplest method to calculate period within which entire
cost of project would be completely recovered. It is the period within which total
cash inflows from project would be equal to total cash outflow of project, cash
inflow means profit after tax but before depreciation.

merits :

a) this method of evaluating proposals for capital budgeting is simple and easy
to understand, it has an advantage of making clear that it has no profit on any
project until the payback period is over i.e. until capital invested is recovered.
When funds are limited, they may be made to do more by selecting projects
having shorter payback periods. This method is particularly suitable in the case
of industries where risk of technological services is very high. In such industries,
only those projects having a shorter payback period should be financed since
changing technology would make the projects totally obsolete, before all costs
are recovered.

b) in case of routine projects also use of payback period method favours projects
that generates cash inflows in earlier years, thereby eliminating projects bringing
cash inflows in later years that generally are conceived to be risky as this tends
to increase with futurity.

c) by stressing earlier cash inflows, liquidity dimension is also considered in

selection criteria. This is
important in situations of liquidity crunch and high cost of capital.

d) payback period can be compared to break-even point, the point at which costs
are fully recovered but profits are yet to commence.

e) the risk associated with a project arises due to uncertainty associated with
cash inflows. A shorter payback period means that uncertainty with respect to
project is resolved faster.

Limitations : Technique of payback period is not a scientific one due to the

following reasons:
a) It stresses capital recovery rather than profitability. It does not take into
account returns from the project after its payback period. For example : project A
may have payback period of 3 years and project B of 8 years, according to this
method project A would be selected, however, it is possible that after 3 years
project B earns returns @ 20 % for another 3 years while project A stops yielding
returns after 2 years. Thus, payback period is not a good measure to evaluate
where the comparison is between 2 projects, one involving long gestation period
and the other yielding quick results but for a short period.

b) this method becomes an inadequate measure of evaluating 2 projects where

the cash inflows are uneven.

c) this method does not give any consideration to time value of money, cash
flows occurring at all points of time are simply added. This treatment is in
contravention of the basic principle of financial analysis that stipulates
compounding or discounting of cash flows and when they arise at different points
of time.

Some accountants calculate payback period after discounting cash

flows by a pre-determined rate and the payback period so calculated is called
"discounted payback period".

2) payback reciprocal :
it is reciprocal of the payback period. A major drawback of the payback
period method of capital budgeting is that it does not indicate any cut off period
for the purpose of investment decision. It is, argued that reciprocal of payback
would be a close approximation of the internal rate of return if the life of the
project is at least twice the payback period and project generates equal amount
of final cash inflows. In practice, payback reciprocal is a helpful tool for quickly
estimating rate of return of a project provided its life is at least twice the
payback period.

payback reciprocal = average annual cash inflows/initial investment

3) accounting or average rate of return method (ARR) :

accounting or average rate of return means average annual yield on
the project. Under this method profit after tax and depreciation as percentage of
total investment is considered.

rate of return = (total profit * 100)/(net investments in the project * number of

years of profits)
this rate is compared with the rate expected on the projects, had the
same funds been invested alternatively in those projects. Sometimes, the
management compares this rate with minimum rate known as cut-off rate.

Merits :
 It is a simple and popular method as it is easy to understand and
includes income from the project throughout its life.

Limitations :
it is based upon crude average profits of the future years. It ignores
the effect of fluctuations in profits from year to year. And thus ignores time value
of money which is very important in capital budgeting decisions.

4) net present value method :

the best method for evaluation of investment proposal is net present
value method or discounted cash flow technique. This method takes into account
the time value of money. The net present value of investment proposal may be
defined as sum of the present values of all cash inflows as reduced by the
present values of all cash outflows associated with the proposal. Each project
involves certain investments and commitment of cash at certain point of time.
This is known as cash outflows. Cash inflows can be calculated by adding
depreciation to profit after tax arising out of that particular project.

NPV = CF 0 /(1+K) 0 + CF 1 /(1+K) 1 .............................+ CF n /(1+K) n

= (t=0 to n) CF t /(1+K) t

Where,
NPV = Net present value of a project
CF 0 = Cash outflows at the time 0(zero).
CF t = Cash flows at the end of year t(t = 0 to n) i.e. the difference between cash
inflow and outflow).
K = Discount rate
n = Life of the project

Discounting cash inflows : Once cash inflows and outflows are

determined, next step is to discount each cash inflow and work out its
present value. For the purpose, discounting rates must be known.
Normally, the discounting rate equals the opportunity cost of capital as a
project must earn at least that much as is paid out on the funds locked in
the project. The concept of present value is easy to understand .To
calculate present value of various cash inflows reference shall be had to
the present value table.

Discounting cash outflows : The cash outflows also requires discounting

as the whole of investment is not made at the initial stage itself and will
be spread over a period of time. This may be due to interest-free deferred
credit facilities from suppliers of plant or some other reasons. Another
change in cash flows to be considered in the capital budgeting decision is
the change due to requirement of working capital. Apart from investment
 in fixed assets, each project involves commitment of funds in working
capital. The commitment on this account may arise as soon as the plant
starts production. The working capital commitment ends after the fixed
assets of the project are sold out. Thus, while considering the total
outflows, working capital requirement must also be considered in the year
the plant starts production. At the end of the project, the working capital
will be recovered and can be treated as cash inflow of last year.
Acceptance rule : A project can be accepted if NPV is positive i.e. NPV >
0 and rejected; if it is negative i.e. NPV < 0. If NPV = 0, project may be
accepted as it implies a project generates cash flows at the rate just
equal to the opportunity cost of capital.

Merits :

1) NPV method takes into account the time value of money.

2) The whole stream of cash flows is considered.

3) NPV can be seen as addition to the wealth of shareholders. The criterion of

NPV is thus in conformity with basic financial objectives.

4) NPV uses discounted cash flows i.e. expresses cash flows in terms of current
rupees. NPV's of different projects therefore can be compared. It implies that
each project can be evaluated independent of others on its own merits.

Limitations :

1) It involves different calculations.

2) The application of this method necessitates forecasting cash flows and the
discount rate. Thus accuracy of NPV depends on accurate estimation of these 2
factors that may be quite difficult in reality.

3) The ranking of projects depends on the discount rate.

5) Desirability factor/Profitability Index :

In cases of, a number of capital expenditure proposals, each involving
different amounts of cash inflows, the method of working out desirability factor or
profitability index is followed. In general terms, a project is acceptable if its
profitability index value is greater than 1.

Merits :

1) This method also uses the concept of time value of money.

2) It is a better project evaluation technique than NPV.

Limitations of Profitability index :

1) Profitability index fails as a guide in resolving 'capital rationing' where

projects are indivisible. Once a single large project with high NPV is selected,
possibility of accepting several small projects that together may have higher
NPV, then a single project is excluded.

2) Situations may arise where a project selected with lower profitability index
may generate cash flows in such a manner that another project can be taken up
one or two years later, the total NPV in such case being more than the one with
a project having highest Profitability Index.

The profitability index approach thus, cannot be used indiscriminately

but all other type of alternatives of projects would have to be worked out.

6) Internal Rate of Return(IRR) :

IRR is that rate of return at which the sum total of discounted cash
inflows equals to discounted cash outflows. The IRR of a project is the discount
rate that makes the net present value of the project equal to zero.

CO 0 = CF 0 /(1+r) 0 + CF 1 /(1+r) 1 .............................+ CF n /(1+r) n + (SV + WC)/(1+r) n

= (t=0 to n) CF t /(1+r) t + (SV + WC)/(1+r) n ...........................................
Where,
CO 0 = Cash outflows at the time 0(zero).
CF t = Cash flows at the end of year t.
r = Discount rate
n = Life of the project
SV & WC = Salvage value and Working capital at the end of 'n' years.

The discount rate i.e. cost of capital is assumed to be known in the

determination of NPV, while in the IRR, the NPV is set at 0(zero) and discount
rate satisfying this condition is determined. IRR can be interpreted in 2 ways :

1) IRR represents the rate of return on the unrecovered investment balance in

the project.

2) IRR is the rate of return earned on the intial investment made in the project.

It may not be possible for all firms to reinvest intermediate cash flows
at a rate of return equal to the project's IRR, hence the first interpretation seems
to be more realistic. Thus, IRR should be viewed as the rate of return on
unrecovered balance of project rather than compounded rate of return on initial
investment over the life of the project. The exact rate of interpolation as follows :

IRR = r + [(PV C FAT - PV C 0 )/ PV * r

Where,
PV C FAT = Present value of cash inflows (DF r * annuity)
PV C 0 = Present value of cash outlay
r = Either of 2 interest rates used in theformula
r = Difference ininterest rates
PV = Difference in present values ofinflows

Acceptance Rule :
The use of IRR, as a criterion to accept capital investmentdecision involves a
comparison of IRR with required rate of return called as Cutoff rate. The project
should the accepted if IRR is greater than cut off rate.If IRR is equal to cut off
rate the firm is indifferent. If IRR less than cutoff rate, the project is rejected.

Merits :

1) This method makes use of the concept of time value ofmoney.

2) All the cash flows in the project areconsidered.

3) IRR is easier to use as instantaneous understanding ofdesirability is

determined by comparing it with
the cost of capital.

4) IRR technique helps in achieving the objective ofminimisation of shareholders

wealth.

Demerits :

1) The calculation process is tedious if there are more thanone cash outflow
interspersed between the cash inflows then there would bemultiple IRR's, the
interpretation of which is difficult.

2) The IRR approach creates a peculiar situation if wecompare the 2 projects

with different inflow/outflow patterns.

3) It is assumed that under this method all future cashinflows of a proposal are
reinvested at a rate equal to IRR which is aridiculous assumption.

4) In case of mutually exclusive projects, investmentoptions have considerably

different cash outlays. A project with large fundcommitments but lower IRR
contribute more in terms of absolute NPV and increasesthe shareholders' wealth
then decisions based only on IRR may not becorrect.
Question : What is the significance of cut off rate?

Answer: Cut off rateis the minimum that the management wishes to have from
any project, usually itis based on cost of capital. The technical calculation of
cost of capitalinvolves a complicated procedure, as a concern procures funds
from any sourcesi.e. equity shares, capital generated from its own operations
and retained ingeneral reserves i.e. retained earnings, debentures, preference
share capital,long/short term loans, etc. Thus, the firm's cost of capital can be
known onlyby working out weighted average of the various costs of raising
various types ofcapital. A firm should not and would not invest in projects
yielding returns ata rate below the cut off rate.

Question : Distinguish between desirability factor, NPV andIRR method of

ranking projects?

Answer :In case of anundertaking having 2 or more competing projects and a

limited amount of fundsat its disposal, the question of ranking the projects
arises. For every project,desirability factor and NPV method would give the same
signal i.e. accept orreject. But, in case of mutually exclusive projects, NPV
method is preferred dueto the fact that NPV indicates economic contribution of
the project in absoluteterms. The project giving higher economic contribution
ispreferred.
As regards NPV vs.IRR method, one has to consider the basic
presumption under each. In case ofIRR, the presumption is that intermediate
cash inflows will be reinvested at therate i.e. IRR, while that under NPV is that
intermediate cash inflows arepresumed to be reinvested at the cut off rate. It is
obvious that reinvestmentof funds at cut off rate is possible than at the internal
rate of return, whichat times may be very high. Hence the NPV obtained after
discounting at a fixedcut off rate are more reliable for ranking 2 or more projects
than theIRR.

Question : Write a note on capital rationing?

Answer :Usually, firmsdecide maximum amount that can be invested in capital

projects, during a givenperiod of time, say a year. The firm, then attempts to
select a combination ofinvestment proposals, that will be within specific limits
providing maximumprofitability and rank them in descending order as per their
rate of return,this is a capital rationing situation. A firm should accept all
investmentprojects with positive NPV, with an objective to maximise the wealth
ofshareholders. However, there may be resource constraints due to which a firm
mayhave to select from amongst various projects. Thus, there may arise a
situationof capital rationing where, there may be internal or external constraints
onprocurement of funds needed to invest in all investment proposals with
positiveNPV's. Capital rationing can be experienced due to external factors,
mainlyimperfections in capital markets attributable to non-availability of
marketinformation, investor attitude, and so on. Internal capital rationing is due
toself-imposed restrictions imposed by management as, not to raise additional
debtor lay down a specified minimum rate of return on each project. There
arevarious ways of resorting to capital rationing. It may put up a ceiling when
ithas been financing investment proposals only by way of retained earnings
i.e.ploughing back of profits. Capital rationing can also be introduced by
followingthe concept of 'Responsibility Accounting', whereby management may
introducecapital rationing by authorising a particular department to invest upto
aspecified limit, beyond which decisions would be taken by the higher-
ups.Selection of a project under capital rationing involves :

1) Identification of the projects that can be accepted byusing evaluation

technique as discussed.

2) Selection of the combination ofprojects.

In capital rationing, it would be desirable to acceptseveral small investment

proposals than a few large ones, for a fullerutilisation of the budgeted amount.
This would result in accepting relativelyless profitable investment proposals if
full utilisation of budget is a primaryconsideration. It may also mean that the firm
forgoes the next profitableinvestment following after the budget ceiling, even if it
is estimated to yielda rate of return higher than the required rate. Thus capital
rationing does notalways lead to optimum results.

Question : Discuss the estimation of future cash flows?

Answer :In order touse any technique of financial evaluation, data as regards
cash flows from theproject is necessary, implying that costs of operations and
returns from theproject for a considerable period in future should be estimated.
Future, isalways uncertain and predictions can be made about it only with
reference tocertain probability levels, but, still would not be exact, thus, cash
flows areat best only a probability. Following are the various stages or steps
used indeveloping relevant information for cash flow analysis :
1)Estimation of costs :To estimate cash outflows, information as regards
followingare needed which may be obtained from vendors or contractors or by
internalestimates :

i) Cost of new equipment;

ii) Cost of removal and disposal of old equipment less scrapvalue;

iii) Cost of preparing the site and mounting of newequipment; and

iv) Cost of ancillary services required for new equipmentsuch as new conveyors
or new power supplies and so on.

The vendor may haverelated data on costs of similar equipment or the

company may have to estimatecosts from its own experience. But, cost of a new
project specially the oneinvolving long gestation period, must be estimated in
view of the changes inprice levels in the economy. For instance high rates of
inflation has causedvery high increases in the cost of various capital projects.
The impact ofpossible inflation on the value of capital goods must thus, be
assessed andestimated in working out estimated cash outflow. Many firms work
out a specificindex showing changes in price levels of capital goods such as
buildings,machinery, plant and machinery, etc. The index is used to estimate the
likelyincrease in costs for future years and as per it, estimated cash outflows
areadjusted. Another adjustment required in cash outflows estimates is
thepossibility of delay in the execution of a project depending on a number
offactors, many of which are beyond the management's control. It is
imperativethat an estimate may be made regarding the increase in project cost
due to delaybeyond expected time. The increase would be due to many factors
as inflation,increase in overhead expenditure, etc.

2)Estimation of additional working capitalrequirements :The next step is

toascertain additional working capital required for financing increased activityon
account of new capital expenditure project. Project planners often do nottake
into account the amount required to finance the increase in additionalworking
capital that may exceed amount of capital expenditure required. Unlessand until
this factor is taken into account, the cash outflow will remainincomplete. The
increase in working capital requirement arises due to the needfor maintaining
higher sundry debtors, stock-in-hand and prepaid expenses, etc.The finance
manager should make a careful estimate of the requirements ofadditional
working capital. As the new capital project commences operation, cashoutflows
requirement should be shown in terms of cash outflows. At the expiry ofthe
useful life of the project, the working capital would be released and can bethus,
treated as cash inflow. The impact of inflation is also to be brought intoaccount,
while working out cash outflows on account of working capital. In aninflationary
economy, working capital requirements may riseprogressively eventhough there
is increase in activity of a new project. This is because the valueof stock, etc.
may rise due to inflation, hence, additional working capitalrequirements on this
account should be shown as cash outflows.

3)Estimation of production and sales :Planning for a new project requires

anestimate of the production that it would generate and the sale that it
wouldentail. Cash inflows are highly dependent on the estimation of production
andsales levels. This dependence is due to peculiar nature of fixed cost.
Cashinflows tend to increase considerably after the sales are above the break-
evenpoint. If in a year, sales are below the break-even point, which is
quitepossible in a large capital intensive project in the initial year of
itscommercial production, the company may even have cash outflows in terms
oflosses. On the basis of additional production units that can be sold and priceat
which they may be sold, the gross revenues from a project can be worked out.In
doing so however, possibility of a reduction in sale price, introduction ofcheaper
or more efficient product by competitors, recession in the marketconditions and
such other factors are to be considered.

4)Estimation of cash expenses :In thisstep, the amount of cash expenses to be

incurred in running the project after itgoes into commercial production are to be
estimated. It is obvious thatwhichever level of capacity utilisation is attained by
the project, fixed costsremains the same. However, variable costs vary with
changes in the level ofcapacity utilisation.

5)Working out cash inflows :The difference between gross revenues and cash
expenses hasto be adjusted for taxation before cash inflows can be worked out.
In view ofdepreciation and other taxable expenses, etc. the tax liability of the
companymay be worked out. The cash inflow would be revenues less cash
expenses andliability for taxation.

One problem is oftreatment of dividends and interest. Some

accountants suggest that interestbeing a cash expense is to be deducted and
dividends to be deducted from cashinflows. However, this seems to be incorrect.
Both dividends and interestinvolve a cash outflow, the fact
remains that these constitute cost of capital, hence, ifdiscounting rate, is itself
based on the cost of capital, interest on long termfunds and dividends to equity
or preference shareholders should not be deductedwhile working out cash
inflows. The rate of return yielded by a project at acertain rate of return is
compared with cost of capital for determining whethera particular project can be
taken up or not. If the cost of capital becomespart of cash outflows, the
comparison becomes vitiated. Thus, capital cost likeinterest on long term funds
and dividends should not be deducted from grossrevenues in order to work out
cash inflows. Cash inflows can also be worked outbackwards, on adding interest
on long term funds and depreciation to net profitsand deducting liability for
taxation for the year.
Question : Write a note on social benefit analysis?

Answer :It is beingincreasingly recognised that commercial evaluation of

industrial projects is notenough to justify commitment of funds to a project
specially, if it belongs tothe public sector and irrespective of its financial
viability, it is to beimplemented in the long term interest of the nation. In the
context of thenational policy of making huge public investments in various
sectors of theeconomy, the need for a practical method of making social cost
benefit analysishas acquired great urgency. Hundreds of crores of rupees are
committed everyyear to various public projects of all types - industrial,
commercial and thoseproviding basic infrastructure facilities, etc. Analysis of
such projects has tobe done with reference to social costs and benefits as they
cannot be expectedto yield an adequate commercial return on the funds
employed, at least duringthe short run. Social cost benefit analysis is important
for privatecorporations having a moral responsibility to undertake socially
desirableprojects. In analysing various alternatives of capital expenditure, a
privatecorporation should keep in view the social contribution aspect. It can thus
beseen that the purpose of social cost benefit analysis technique is not
toreplace the existing techniques of financial analysis but to supplement
andstrengthen them. The concept of social cost benefit analysis has
progressedbeyond the stage of intellectual speculation. The planning
commission hasalready decided that in future, the feasibility studies for public
sectorprojects will have to include an analysis of the social rate of return. In
caseof private sector also, a socially beneficial project may be more
easilyacceptable to the government and thus, this analysis would be relevant
whilegranting various licenses and approvals, etc. Also, if the private
sectorincludes social cost benefit analysis in its project evaluation techniques,
itwill ensure that it is not ignoring its own long-term interest, as in the longrun
only those projects will survive that are socially beneficial and acceptableto
society.

Need for Social Cost Benefit Analysis (SCBA) :

1) Market prices used to measurecosts and benefits inproject analysis do not

represent social values due to marketimperfections.

2) Monetary cost benefit analysis fails to consider theexternalities or external

effects of a project. The external effects can bepositive like development of
infrastructure or negative like pollution andimbalance in environment.

3) Taxes and subsidies are monetary costs and gains, butthese are only transfer
payments from social viewpoint and thusirrelevant.
4) SCBA is essential for measuring the redistribution effectof benefits of a
project as benefits going to poorer section are more importantthan one going to
sections which are economically better off.

5) Projects manufacturing liqueur and cigarettes are notdistinguished from those

generating electricity or producing necessities oflife. Thus, merit wants are
important appraisal criterion forSCBA.

The importantpublication on the technique of social cost benefit

analysis are those by theUnited Nations Industrial Development
Organisation(UNIDO) and the Centre forOrganisation of Economic Cooperation
and Development(OECD). Both publicationdeal with the problem of measuring
social costs and benefits. In this context,it is essential to understand that actual
cost or revenues do not essentiallyreflect cost or benefit to the society. It is so,
because the market price ofgoods and services are often grossly distorted due to
various artificialrestrictions and controls from authorities. Thus, a different
yardstick is to beadopted in evaluating a particular proposal and its cost benefit
analysis areusually valued at "opportunity cost" or shadow prices to judge the
real impactof their burden as costs to society. The social cost valuation
sometimescompletely changes the estimates of working results of aproject.

Question : Is there any relationship between risk andreturn, if yes, of what

sort?

Answer :
Risk :The term risk with reference to investment decision isdefined as the
variability in actual return emanating from a project in futureover its working life
in relation to the estimated return as forecasted at thetime of initial capital
budgeting decisions. Risk is differentiated withuncertainty and is defined as a
situation where the facts and figures are notavailable or probabilities cannot be
assigned.

Return :It cannot be denied that return is themotivating force and the principal
reward to the investment process. The returnmay be defined in terms of :

1) realised return i.e. the return which was earned or couldhave been earned,
measuring the realised return allows a firm to assess how thefuture expected
returns may be.

2) expected return i.e. the return that the firm anticipatesto earn over some
future period. The expected return is a predicted return andmay or may not
occur.
 For, a firm thereturn from an investment is the expected cash inflows.
The return may bemeasured as the total gain or loss to the firm over a given
period of time andmay be defined as percentage on the initial amount invested.

Relationship between risk and return :The main objectiveof financial

management is to maximise wealth of shareholders' as reflected inthe market
price of shares, that depends on risk-return characteristics of thefinancial
decisions taken by the firm. It also emphasizes that risk and returnare 2
important determinants of value of a share. So, a finance manager as
alsoinvestor, in general has to consider the risk and return of each and
everyfinancial decision. Acceptance of any proposal does not alter the business
riskof firm as perceived by the supplier of capital, but, different
investmentprojects would have different degree of risk. Thus, the importance of
riskdimension in capital budgeting can hardly be over-stressed. In fact, risk
andreturn are closely related, investment project that is expected to yield
highreturn may be too risky that it causes a significant increase in the
perceivedrisk of the firm. This trade off between risk and return would have a
bearing onthe investor' perception of the firm before and after acceptance of a
specificproposal. The return from an investment during a given period is equal to
thechange in value of investment plus any income received from investment. It
isthus, important that any capital or revenue income from investments to
investormust be included, otherwise the measure of return will be deficient. The
returnfrom investment cannot be forecasted with certainty as there is risk that
thecash inflows from project may not be as expected. Greater the
variabilitybetween the estimated and actual return, more risky is theproject.

CHAPTER FIVE

LEVERAGE

Question : Discuss the concept of leverage and its types ?

Answer : the term leverage generally, refers to a relationship between 2

interrelated variables. In financial analysis, it represents the influence of one
financial variable over some other related financial variable. These financial
variables may be costs, output, sales revenue, EBIT (Earnings Before Interest
and Tax), EPS (Earnings Per Share), etc.

Types of leverages : Commonly used leverages are of the following type :

1) Operating Leverage :
It is defined as the "firm's ability to use fixed operating costs to magnify effects
of changes in sales on its EBIT ". When there is an increase or decrease in sales
level the EBIT also changes. The effect of changes in sales on the level EBIT is
measured by operating leverage.

Operating leverage = % Change in EBIT / % Change in sales

= [Increase in EBIT/EBIT] / [Increase in sales/sales]

Significance of operating leverage : Analysis of operating leverage of a firm is

useful to the financial manager. It tells the impact of changes in sales on
operating income. A firm having higher D.O.L. (Degree of Operating Leverage)
can experience a magnified effect on EBIT for even a small change in sales
level. Higher D.O.L. can dramatically increase operating profits. But, in case of
decline in sales level, EBIT may be wiped out and a loss may be operated. As
operating leverage, depends on fixed costs, if they are high, the firm's operating
risk and leverage would be high. If operating leverage is high, it automatically
means that the break-even point would also be reached at a high level of sales.
Also, in case of high operating leverage, the margin of safety would be low.
Thus, it is preferred to operate sufficiently above the break-even point to avoid
the danger of fluctuations in sales and profits.

2) Financial Leverage :
It is defined as the ability of a firm to use fixed financial charges to magnify the
effects of changes in EBIT/Operating profits, on the firm's earnings per share.
The financial leverage occurs when a firm's capital structure contains obligation
of fixed charges e.g. interest on debentures, dividend on preference shares, etc.
along with owner's equity to enhance earnings of equity shareholders. The fixed
financial charges do not vary with the operating profits or EBIT. They are fixed
and are to be repaid irrespective of level of operating profits or EBIT. The
ordinary shareholders of a firm are entitled to residual income i.e. earnings after
fixed financial charges. Thus, the effect of changes in operating profit or EBIT on
the level of EPS is measured by financial leverage.

Financial leverage = % change in EPS/% change in EBIT

or
= (Increase in EPS/EPS)/{Increase in EBIT/EBIT}
The financial leverage is favourable when the firm earns more on the
investment/assets financed by sources having fixed charges. It is obvious that
shareholders gain a situation where the company earns a high rate of return and
pays a lower rate of return to the supplier of long term funds, in such cases it is
called 'trading on equity'. The financial leverage at the levels of EBIT is called
degree of financial leverage and is calculated as ratio of EBIT to profit before
tax.
 Degree of financial leverage = EBIT/Profit before tax
Shareholders gain in a situation where a company has a high rate of return and
pays a lower rate of interest to the suppliers of long term funds. The difference
accrues to the shareholders. However, where rate of return on investment falls
below the rate of interest, the shareholders suffer, as their earnings fall more
sharply than the fall in the return on investment.

Financial leverage helps the finance manager in designing the appropriate

capital structure. One of the objective of planning an appropriate capital
structure is to maximise return on equity shareholders' funds or maximise EPS.
Financial leverage is double edged sword i.e. it increases EPS on one hand, and
financial risk on the other. A high financial leverage means high fixed costs and
high financial risk i.e. as the debt component in capital structure increases, the
financial risk also increases i.e. risk of insolvency increases. The finance
manager thus, is required to trade off i.e. to bring a balance between risk and
return for determining the appropriate amount of debt in the capital structure of a
firm. Thus, analysis of financial leverage is an important tool in the hands of the
finance manager who are engaged in financing the capital structure of business
firms, keeping in view the objectives of their firm.

3) Combined leverage :
Operating leverage explains operating risk and financial leverage explains the
financial risk of a firm. However, a firm has to look into overall risk or total risk
of the firm i.e. operating risk as also financial risk. Hence, the combined
leverage is the result of a combination of operating and financial leverage. The
combined leverage measures the effect of a % change in sales on % change in
EPS.

Combined Leverage = Operating leverage * Financial leverage

= (% change in EBIT/% change in sales) * (% change in
EPS/% change in EBIT)
= % change in EPS/% change in sales

The ratio of contribution to earnings before tax, is given by a combined effect of

financial and operating leverage. A high operating and high financial leverage is
very risky, even a small fall in sales would affect tremendous fall in EPS. A
company must thus, maintain a proper balance between these 2 leverage. A high
operating and low financial leverage indicates that the management is careful as
higher amount of risk involved in high operating leverage is balanced by low
financial leverage. But, a more preferable situation is to have a low operating
and a high financial leverage. A low operating leverage automatically implies that
the company reaches its break-even point at a low level of sales, thus, risk is
diminished. A highly cautious and conservative manager would keep both its
operating and financial leverage at very low levels. The approach may, mean
that the company is losing profitable opportunities.
The study of leverages is essential to define the risk undertaken by the
shareholders. Earnings available to shareholders fluctuate on account of 2 risks,
viz. operating risk i.e. variability of EBIT may arise due to variability of sales
or/and expenses. In a given environment, operating risk cannot be avoided. The
variability of EPS or return on equity depends on the use of financial leverage
and is termed as financial risk. A firm financed totally by equity finance has no
financial risk, hence it cannot be avoided by eliminating use of borrowed funds.
Thus, a company has to consider its likely profitability position set before
deciding upon the capital mix of the company, as it has far reaching implications
on the financial position of the company.

Question : What is the effect of leverage on capital turnover and working

capital ratio ?

Answer : An increase in sales improves the net profit ratio, raising the Return
on Investment (R.O.I) to a higher level. This however, is not possible in all
situations, a rise in capital turnover is to be supported by adequate capital base.
Thus, as capital turnover ratio increases, working capital ratio deteriorates, thus,
management cannot increase its capital turnover ratio beyond a certain limit.
The main reasons for a fall in ratios showing the working capital position due to
increase in turnover ratios is that as the activity increases without a
corresponding rise in working capital, the working capital position becomes tight.
As the sales increases, both current assets and current liabilities also increases
but not in proportion to current ratio. If current ratio and acid test ratio are high,
it is apparent that the capital turnover ratio can be increased without any
problem. However, it may be very risky to increase capital turnover ratio when,
the working capital position is not satisfactory.

CHAPTER SIX

CAPITAL STRUCTURE AND COST OF CAPITAL

Question : Explain the concept of capital structure ?

Answer : A finance manager for procurement of funds, is required to select such

a finance mix or capital structure that maximises shareholders wealth. For
designing optimum capital structure he is required to select such a mix of
sources of finance, so that the overall cost of capital is minimum. Capital
structure refers to the mix of sources from where long term funds required by a
business may be raised i.e. what should be the proportion of equity share
capital, preference share capital, internal sources, debentures and other sources
of funds in total amount of capital which an undertaking may raise for
establishing its business. In planning the capital structure, following must be
referred to :

1) There is no definite model that can be suggested/used as an ideal for all

business undertakings. This is due to varying circumstances of various business
undertakings. Capital structure depends primarily on a number of factors like,
nature of industry, gestation period, certainty with which the profits will accrue
after the undertaking commences commercial production and the likely quantum
of return on investment. It is thus, important to understand that different types of
capital structure would be required for different types of undertakings.

2) Government policy is a major factor in planning capital structure. For

instance, a change in the lending policy of financial institutions may mean a
complete change in the financial pattern. Similarly, rules and regulations for
capital market formulated by SEBI affect the capital structure decisions. The
finance managers of business concerns are required to plan capital structure
within these constraints.

Optimum capital structure : The capital structure is said to be optimum, when

the company has selected such a combination of equity and debt, so that the
company's wealth is maximum. At this, capital structure, the cost of capital is
minimum and market price per share is maximum. But, it is difficult to measure a
fall in the market value of an equity share on account of increase in risk due to
high debt content in the capital structure. In reality, however, instead of
optimum, an appropriate capital structure is more realistic. Features of an
appropriate capital structure are as below :

1) Profitability : The most profitable capital structure is one that tends to

minimise financing cost and maximise of earnings per equity share.

2) Flexibility : The capitals structure should be such that the company is able to
raise funds whenever needed.

3) Conservation : Debt content in capital structure should not exceed the limit
which the company can bear.

4) Solvency : Capital structure should be such that the business does not run
the risk of insolvency.

5) Control : Capital structure should be devised in such a manner that it

involves minimum risk of loss of control over the company.
Question : Explain the major considerations in the planning of capital
structure ?

Answer : The 3 major considerations evident in capital structure planning are

risk, cost and control, they assist the management in determining the proportion
of funds to be raised from various sources. The finance manager attempts to
design the capital structure in a manner, that his risk and cost are least and
there is least dilution of control from the existing management. There are also
subsidiary factors as, marketability of the issue, maneuverability and flexibility of
capital structure and timing of raising funds. Structuring capital, is a shrewd
financial management decision and is something that makes or mars the fortunes
of the company. The factors involved in it are as follows :

1) Risk :
Risks are of 2 kinds viz. financial and business risk. Financial risk is
of 2 kinds as below :

i) Risk of cash insolvency : As a business raises more debt, its risk of cash
insolvency increases, as :

a) the higher proportion of debt in capital structure increases the commitments

of the company with regard to fixed charges. i.e. a company stands committed to
pay a higher amount of interest irrespective of the fact whether or not it has
cash. and

b) the possibility that the supplier of funds may withdraw funds at any point of
time.
Thus, long term creditors may have to be paid back in installments, even if
sufficient cash to do so does not exist. Such risk is absent in case of equity
shares.

ii) Risk of variation in the expected earnings available to equity share-

holders : In case a firm has a higher debt content in capital structure, the risk of
variations in expected earnings available to equity shareholders would be higher;
due to trading on equity. There is a lower probability that equity shareholders get
a stable dividend if, the debt content is high in capital structure as the financial
leverage works both ways i.e. it enhances shareholders' returns by a high
magnitude or reduces it depending on whether the return on investment is higher
or lower than the interest rate. In other words, there is relative dispersion of
expected earnings available to equity shareholders, that would be greater if
capital structure of a firm has a higher debt content.
 The financial risk involved in various sources of funds may be
understood with the help of debentures. A company has to pay interest charges
on debentures even in case of absence of profits. Even the principal sum has to
be repaid under the stipulated agreement. The debenture holders have a charge
against the company's assets and thus, they can enforce a sale of assets in case
of company's failure to meet its contractual obligations. Debentures also
increase the risk of variation in expected earnings available to equity
shareholders through leverage effect i.e. if return on investment remains higher
than interest rate, shareholders get a high return and vice versa. As compared to
debentures, preference shares entail a slightly lower risk for the company, as the
payment of dividends on such shares is contingent upon the earning of profits by
the company. Even in case of cumulative preference shares, dividends are to be
paid only in the year in which company earns profits. Even, their repayment is
made only if they are redeemable and after a stipulated period. However,
preference shares increase the variations in expected earnings available to
equity shareholders. From the company's view point, equity shares are least
risky, as a company does not repay equity share capital except on its liquidation
and may not declare dividends for years. Thus, as seen here, financial risk
encompasses the volatility of earnings available to equity shareholders as also,
the probability of cash insolvency.

2) Cost of capital :
Cost is an important consideration in capital structure decisions and it
is obvious that a business should be atleast capable of earning enough revenue
to meet its cost of capital and also finance its growth. Thus, along with risk, the
finance manager has to consider the cost of capital factor for determination of
the capital structure.

3) Control :
Along with cost and risk factors, the control aspect is also an
important factor for capital structure planning. When a company issues equity
shares, it automatically dilutes the controlling interest of present owners. In the
same manner, preference shareholders can have voting rights and thereby affect
the composition of Board of directors, if dividends are not paid on such shares
for 2 consecutive years. Financial institutions normally stipulate that they shall
have one or more directors on the board. Thus, when management agrees to
raise loans from financial institutions, by implication it agrees to forego a part of
its control over the company. It is thus, obvious that decisions concerning capital
structure are taken after keeping the control factor in view.

4) Trading on equity :
A company may raise funds by issue of shares or by borrowings,
carrying a fixed rate of interest that is payable irrespective of the fact whether or
not there is a profit. Preference shareholders are also entitled to a fixed rate of
dividend, but dividend payment is subject to the company's profitability. In case
of ROI the total capital employed i.e. shareholders' funds plus long term
borrowings, is more than the rate of interest on borrowed funds or rate of
dividend on preference shares, the company is said to trade on equity. It is the
finance manager's main objective to see that the return and overall wealth of the
company both are maximised, and it is to be kept in view while deciding on the
sources of finance. Thus, the effect of each proposed method of new finance on
EPS is to be carefully analysed. This, thus, helps in deciding whether funds
should be raised by internal equity or by borrowings.

5) Corporate taxation :
Under the Income tax laws, dividend on shares is not deductible while
interest paid on borrowed capital is allowed as deduction. Cost of raising finance
through borrowings is deductible in the year in which it is incurred. If it is
incurred during the pre-commencement period, it is to be capitalised. Cost of
share issue is allowed as deduction. Owing to such provisions, corporate
taxation, plays an important role in determination of the choice between different
sources of financing.

6) Government Policies :
Government policies is a major factor in determining capital structure.
For instance, a change in the lending policies of financial institutions would
mean a complete change in the financial pattern followed by companies. Also,
rules and regulations framed by SEBI considerably affect the capital issue policy
of various companies. Monetary and fiscal policies of government also affect the
capital structure decisions.

7) Legal requirements :
The finance manager has to keep in view the legal requirements at the
time of deciding as regards the capital structure of the company.

8) Marketability :
To obtain a balanced capital structure, it is necessary to consider the
company's ability to market corporate securities.

9) Maneuverability :
Maneuverability is required to have as many alternatives as possible at
the time of expanding or contracting the requirement of funds. It enables use of
proper type of funds available at a given time and also enhances the bargaining
power when dealing with the prospective suppliers of funds.

10) Flexibility :
It refers to the capacity of the business and its management to adjust to
expected and unexpected changes in circumstances. In other words, the
management would like to have a capital structure providing maximum freedom
to changes at all times.
11) Timing :
Closely related to flexibility is the timing for issue of securities. Proper
timing of a security issue often brings substantial savings due to the dynamic
nature of the capital market. Intelligent management tries to anticipate the
climate in capital market with a view to minimise cost of raising funds and the
dilution resulting from an issue of new ordinary shares.

12) Size of the company :

Small companies rely heavily on owner's funds while large companies
are usually considered, to be less risky by investors and thus, they can issue
different types of securities.

13) Purpose of financing :

The purpose of financing also, to some extent affects the capital
structure of the company. In case funds are required for productive purposes like
manufacturing, etc. the company may raise funds through long term sources. On
the other hand, if the funds are required for non-productive purposes, like
welfare facilities to employees such as schools, hospitals, etc. the company may
rely only on internal resources.

14) Period of Finance :

The period for which finance is required also affects the determination
of capital structure. In case funds are required for long term requirements say 8
to 10 years, it would be appropriate to raise borrowed funds. However, if the
funds are required more or less permanently, it would be appropriate to raise
borrowed funds. However, if the funds are required more or less permanently, it
would be appropriate to raise them by issue of equity shares.

15) Nature of enterprise :

The nature of enterprise to a great extent affects the company's capital
structure. Business enterprises having stability in earnings or enjoying monopoly
as regards their products may go for borrowings or preference shares, as they
have adequate profits to pay interest/fixed charges. On the contrary, companies
not having assured income should preferably rely on internal resources to a
large extent.

16) Requirement of investors :

Different types of securities are issued to different classes of investors
according to their requirement.

17) Provision for future :

While planning capital structure the provision for future requirement of
capital is also required to be considered.
Question : Give in detail the various capital structure theories ?

Answer : A firm's objective should be directed towards the maximisation of the

firm's value; the capital structure or leverage decision are to examined from the
view point of their impact on the value of the firm. If the value of the firm can be
affected by capital structure or financing decision, a firm would like to have a
capital structure that maximises the market value of the firm. There are broadly
4 approaches in the regard, which analyses relationship between leverage, cost
of capital and the value of the firm in different ways, under the following
assumptions :

1) There are only 2 sources of funds viz. debt and equity.

2) The total assets of the firm are given and the degree of leverage can be
altered by selling debt to repurchase shares or selling shares to retire debt.

3) There are no retained earnings implying that entire profits are distributed
among shareholders.

4) The operating profit of firm is given and expected to grow.

5) The business risk is assumed to be constant and is not affected by the

financing mix decision.

6) There are no corporate or personal taxes.

7) The investors have the same subjective probability distribution of expected

earnings.

The approaches are as below :

1) Net Income Approach (NI Approach) :

The approach is suggested by Durand. According to it, a firm can
increase its value or lower the overall cost of capital by increasing the
proportion of debt in the capital structure. In other words, if the degree of
financial leverage increases, the weighted average cost of capital would decline
with every increase in the debt content in total funds employed, while the value
of the firm will increase. Reverse would happen in a converse situation. It is
based on the following assumptions :

i) There are no corporate taxes.

ii) The cost of debt is less than cost of equity or equity capitalisation rate.

iii) The use of debt content does not change the risk perception of investors as a
result of both the K d (Debt capitalisation rate) and K e (equity capitalisation rate)
remains constant.

The value of the firm on the basis of Net Income Approach may be
ascertained as follows :

V=S+D

Where,
V = Value of the firm
S = Market value of equity
D = Market value of debt

S = NI/K e

Where,
S = Market value of equity
NI = Earnings available for equity shareholders
K e = Equity Capitalisation rate
Under, NI approach, the value of a firm will be maximum at a point where
weighted average cost of capital is minimum. Thus, the theory suggests total or
maximum possible debt financing for minimising cost of capital.

Overall cost of capital = EBIT/Value of the firm

2) Net Operating Income Approach (NOI) :

This approach is also suggested by Durand, according to it, the market
value of the firm is not affected by the capital structure changes. The market
value of the firm is ascertained by capitalising the net operating income at the
overall cost of capital, which is constant. The market value of the firm is
determined as :
V = EBIT/Overall cost of capital
Where,
V = Market value of the firm
EBIT = Earnings before interest and tax
S=V-D

Where,
S = Value of equity
D = Market value of debt
V = Market value of firm
Cost of equity = EBIT/(V - D)
Where,
V = Market value of the firm
EBIT = Earnings before interest and tax
D = Market value of debt

It is based on the following assumptions :

i) The overall cost of capital remains constant for all degree of debt equity mix.

ii) The market capitalises value of the firm as a whole. Thus, the split between
debt and equity is not important.

iii) The use of less costly debt funds increases the risk of shareholders. This
causes the equity capialisation rate to increase. Thus, the advantage of debt is
set off exactly by increase in equity capitalisation rate.

iv) There are no corporate taxes.

v) The cost of debt is constant.

Under, NOI approach since overall cost of capital is constant, thus,

there is no optimal capital structure rather every capital structure is as good as
any other and so every capital structure is optimal.

3) Traditional Approach :
The traditional approach, also called an intermediate approach as it
takes a midway between NI approach, that the value of the firm can be increased
by increasing financial leverage and NOI approach, that the value of the firm is
constant irrespective of the degree of financial leverage. According to this
approach the firm should strive to reach the optimal capital structure and its
total valuation through a judicious use of debt and equity in capital structure. At
the optimal capital structure, the overall cost of capital will be minimum and the
value of the firm is maximum. It further states, that the value of the firm
increases with financial leverage upto a certain point. Beyond this, the increase
in financial leverage will increase cost of equity, the overall cost of capital may
still reduce. However, if financial leverage increases beyond an acceptable limit,
the risk of debt investor may also increase, consequently cost of debt also starts
increasing. The increasing cost of equity owing to increased financial risk and
increasing cost of debt makes the overall cost of capital to increase. Thus, as
per the traditional approach the cost of capital is a function of financial leverage
and the value of firm can be affected by the judicious mix of debt and equity in
capital structure. The increase of financial leverage upto a point favourably
affect the value of the firm. At this point, the capital structure is optimal & the
overall cost of capital will be the least.

4) Modigliani and Miller Approach(MM Approach) :

According to this approach, the total cost of capital of particular firm is
independent of its method and level of financing. Modigliani and Miller argued
that the weighted average cost of capital of a firm is completely independent of
its capital structure. In other words, a change in the debt equity mix does not
affect the cost of capital. They argued, in support of their approach, that as per
the traditional approach, cost of capital is the weighted average of cost of debt
and cost of equity, etc. The cost of equity, is determined from the level of
shareholder's expectations. That is if, shareholders expect a particular rate of
return, say 15 % from a particular company, they do not take into account the
debt equity ratio and they expect 15 % as they find that it covers the particular
risk which this company entails. Suppose, the debt content in the capital
structure of the company increases, this means, that in the eyes of shareholders,
the risk of the company increases, since debt is a more risky mode of finance.
Thus, the shareholders would now, expect a higher rate of return from the shares
of the company. Thus, each change in the debt equity mix is automatically set-off
by a change in the expectations of the shareholders from the equity share
capital. This is because, a change in the debt-equity ratio changes the risk
element of the company, which in turn changes the expectations of the
shareholders from the particular shares of the company. Modigliani and Miller,
thus, argue that financial leverage has nothing to do with the overall cost of
capital and the overall cost of capital is equal to the capitalisation rate of pure
equity stream of its class of risk. Thus, financial leverage has no impact on
share market prices nor on the cost of capital. They make the following
propositions :

i) The total market value of a firm and its cost of capital are independent of its
capital structure. The total market value of the firm is given by capitalising the
expected stream of operating earnings at a discount rate considered appropriate
for its risk class.

ii) The cost of equity (Ke) is equal to the capitalisation rate of pure equity stream
plus a premium for financial risk. The financial risk increases with more debt
content in the capital structure. As a result, Ke increases in a manner to offset
exactly the use of less expensive sources of funds.

iii) The cut off rate for investment purposes is completely independent of the way
in which the investment is financed.

Assumptions :
i) - The capital markets are assumed to be perfect. This means that investors are
free to buy and sell securities.
- They are well-informed about the risk-return on all type of securities.
- There are no transaction costs.
- They behave rationally.
- They can borrow without restrictions on the same terms as the firms do.

ii) The firms can be classified into 'homogenous risk class'. They belong to this
class, if their expected earnings have identical risk characteristics.

iii) All investors have the same expectations from a firms' EBIT that is necessary
to evaluate the value of a firm.

iv) The dividend payment ratio is 100 %. i.e. there are no retained earnings.

v) There are no corporate taxes, but, this assumption has been removed.

Modigliani and Miller agree that while companies in different industries

face different risks resulting in their earnings being capitalised at different rates,
it is not possible for these companies to affect their market values, and thus,
their overall capitalisation rate by use of leverage. That is, for a company in a
particular risk class, the total market value must be same irrespective of
proportion of debt in company's capital structure. The support for this hypothesis
lies in the presence of arbitrage in the capital market. They contend that
arbitrage will substitute personal leverage for corporate leverage.
For instance : There are 2 companies X and Y in the same risk class. Company X
is financed by only equity and no debt, while Company Y is financed by a
combination of debt and equity. The market price of shares of Company Y would
be higher than that of Company X, market participants would take advantage of
difference by selling equity shares of Company Y, borrowing money to equate
their personal leverage to the degree of corporate leverage in Company Y and
use them for investing in Company X. The sale of shares of Company Y reduces
its price until the market value of the company Y, financed by debt and equity,
equals that of Company X, financed by only equity.

Criticism :
These propositions have been criticised by numerous authorities. Mostly
criticism is as regards, perfect market and arbitrage assumption. MM hypothesis
argue that through personnel arbitrage investors would quickly eliminate any
inequalities between the value of leveraged firms and that of unleveraged firms
in the same risk class. The basic argument here, is that individual arbitrageurs,
through the use of personal leverage can alter corporate leverage, which is not a
valid argument in the practical world, as it is extremely doubtful that personal
investors would substitute personal leverage for corporate leverage, as they do
not have the same risk characteristics. The MM approach assumes availability of
free and upto date information, this also is not normally valid.

To conclude, one may say that controversy between the traditionalists

and the supporters of MM approach cannot be resolved due to lack of empirical
research. Traditionalists argue that the cost of capital of a firm can be lowered
and the market value of shares increased by use of financial leverage. But, after
a certain stage, as the company becomes highly geared i.e. debt content
increases, it becomes too risky for investors and lenders. Thus, beyond a point,
the overall cost of capital begins to rise, this point indicates the optimal capital
structure. Modigliani and Miller argues, that in the absence of corporate income
taxes, overall cost of capital begins to rise.

Question : What kind of relationship exists between taxation and capital

structure ?

Answer : The leverage irrelevance theory of MM is valid only in perfect market

conditions, but, in face of imperfections characterising the real world capital
markets, the capital structure of a firm may affect its valuation. Presence of
taxes is a major imperfection in the real world. When taxes are applicable to
corporate income, debt financing is advantageous. This is because dividends
and retained earnings are not deductible for tax purposes, interest on debt is a
deductible expense for tax purposes. As a result, the total available income for
both stock-holders and debt-holders is greater when debt capital is used. If the
debt employed by a leveraged firm is permanent in nature, the present value of
the tax shield associated with interest payment can be obtained by applying the
formula for perpetuity.

Present value of tax shield (TD) = (T * k d * D)/k d

Where,
T = Corporate tax rate
D = Market value of debt
k d = Interest rate on debt

The present value of interest tax shields is independent of the cost of

debt, it being a deductible expense. It is simply the corporate tax rate times the
amount of permanent debt.

Value of an unleveraged firm :

V u = [EBIT ( 1 - t )]/K 0

Value of leveraged firm :

 V l = V u + Debt (t)

Greater the leverage, greater would be the value of the firm, other
things being equal. This implies that the optimal strategy of a firm should be to
maximise the degree of leverage in its capital structure.

Question : Enumerate the methods to calculate the cost of capital from

various sources ?

Answer : The cost of capital is a significant factor in designing the capital

structure of an undertaking, as basic reason of running of a business
undertaking is to earn return at least equal to the cost of capital. Commercial
undertaking has no relevance if, it does not expect to earn its cost of capital.
Thus cost of capital constitutes an important factor in various business
decisions. For example, in analysing financial implications of capital structure
proposals, cost of capital may be taken as the discounting rate. Obviously, if a
particular project gives an internal rate of return higher than its cost of capital, it
should be an attractive opportunity. Following are the cost of capital acquired
from various sources :

1) Cost of debt :
The explicit cost of debt is the interest rate as per contract adjusted for tax and
the cost of raising debt.
- Cost of irredeemable debentures :
Cost of debentures not redeemable during the life time of the company,

K d = (I/NP) * (I - T)

Where,
K d = Cost of debt after tax
I = Annual interest rate
NP = Net proceeds of debentures
T = Tax rate

However, debt has an implicit cost also, that arises due to the fact that
if the debt content rises above the optimal level, investors would start
considering the company to be too risky and, thus, their expectations from equity
shares will rise. This rise, in the cost of equity shares is actually the implicit cost
of debt.

- Cost of redeemable debentures :

 If the debentures are redeemable after the expiry of a fixed period the
cost of debentures would be :

K d = I(1 - t) + [(RV - NP)]/N

[(RV + NP)/2]

Where,
I = Annual interest payment
NP = Net proceeds of debentures
RV = Redemption value of debentures
t = tax rate
N = Life of debentures

2) Cost of preference shares :

In case of preference shares, the dividend rate can be taken as its
cost, as it is this amount that the company intends to pay against the preference
shares. As, in case of debt, the issue expenses or discount/premium on
issue/redemption is also to be taken into account.

- Cost of irredeemable preference shares :

Cost of irredeemable preference shares = PD/PO

Where,
PD = Annual preference dividend
PO = Net proceeds of an issue of preference shares

- Cost of redeemable preference shares :

If the preference shares are redeemable after the expiry of a fixed
period, the cost of preference shares would be.

K p = PD + [(RV - NP)]/N
[(RV + NP)/2]
Where,
PD = Annual preference dividend
NP = Net proceeds of debentures
RV = Redemption value of debentures
N = Life of debentures

However, since dividend of preference shares is not allowed as

deduction from income for income tax purposes, there is no question of tax
advantage in the case of cost of preference shares. It would, thus, be seen that
both in case of debt and preference shares, cost of capital is calculated by
reference to the obligations incurred and proceeds received. The net proceeds
received must be taken into account in working cost of capital.
3) Cost of ordinary or equity shares :
Calculation of the cost of ordinary shares involves a complex
procedure, because unlike debt and preference shares there is no fixed rate of
interest or dividend against ordinary shares. Hence, to assign a certain cost to
equity share capital is not a question of mere calculation, it requires an
understanding of many factors basically concerning the behaviour of investors
and their expectations. As, there can be different interpretations of investor's
behaviour, there are many approaches regarding calculation of cost of equity
shares. The 4 main approaches are :

i) D/P ratio (Dividend/Price) approach : This emphasises that dividend

expected by an investor from a particular share determines its cost. An investor
who invests in the ordinary shares of a particular company, does so in the
expectation of a certain return. In other words, when an investor buys ordinary
shares of a certain risk, he expects a certain return, The expected rate of return
is the cost of ordinary share capital. Under this approach, thus, the cost of
ordinary share capital is calculated on the basis of the present value of the
expected future stream of dividends.
For example, the market price of the equity shares (face value Rs. 10)
of a particular company is Rs. 15. If it has been paying a dividend of 20 % and is
expected to maintain the same, its cost of equity shares at face value is 0.2 *
10/15 = 13.3%, since it is the maximum rate of dividend, at which the investor
will buy share at the present value. However, it can also be argued that the cost
of equity capital is 20 % for the company, as it is on this expectation that the
market price of shares is maintained at Rs. 15. Cost of equity shares of a
company is that rate of dividend that maintains the present market price of
shares. As the objective of financial management is to maximise the wealth of
shareholders, it is rational to assume that the company must maintain the
present market value of its share by paying 20 % dividend, which then is its cost
of equity capital. Thus, the relationship between dividends and market price
shows the expectation of the investors and thereby cost of equity capital.
This approach co-relates the basic factors of return and investment from
view point of investor. However, it is too simple as it pre-supposes that an
investor looks forward only to dividends as a return on his investment. The
expected stream of dividends is of importance to an investor but, he looks
forward to capital appreciation also in the value of shares. It may lead us to
ignore the growth in capital value of the share. Under, this approach, a company
which declares a higher amount of dividend out of a given quantum of earnings
will be placed at a premium as compared to a company which earns the same
amount of profits but utilises a major part of the same in financing its expansion
programmes. Thus, D/P approach may not be adequate to deal with the problem
of determining the cost of ordinary share capital.

ii) E/P (Earnings/Price) ratio approach : The advocates of this approach co-
relates the earnings of the company with the market price of its shares. As per it,
the cost of ordinary share capital would be based on the expected rate of
earnings of a company. The argument is that each investor expects a certain
amount of earnings, whether distributed or not from the company in whose
shares he invests, thus, an investor expects that the company in which he is
going to subscribe for share should have at least 20 % of earning, the cost of
ordinary share capital can be construed on this basis. Suppose, a company is
expected to earn 30 % the investor will be prepared to pay Rs 150 (30/20 * 100)
for each of Rs. 100 share. This approach is similar to the dividend price
approach, only it seeks to nullify the effect of changes in dividend policy. This
approach also does not seem to be a complete answer to the problem of
determining the cost of ordinary share as it ignores the factor of capital
appreciation or depreciation in the market value of shares.

iii) D/P + growth approach : The dividend/price + growth approach emphasises

what an investor actually expects to receive from his investment in a particular
company's ordinary share in terms of dividend plus the rate of growth in
dividend/earnings. This growth rate in dividend (g) is taken to be good to the
compound growth rate in earnings per share.

K e = [D 1 /P 0 ] + g
Where,
K e = Cost of capital
D 1 = Dividend for the period 1
P 0 = Price for the period 0
g = Growth rate
D/P + g approach seems to answer the problem of expectations of
investor satisfactorily, however, it poses one problem that is how to quantify
expectation of investor relating to dividend and growth in dividend.

iv) Realised yield approach : It is suggested that many authors that the yield
actually realised for a period of time by investors in a particular company may be
used as an indicator of cost of capital. In other words, this approach takes into
consideration the basic factor of the D/P + g approach but, instead of using the
expected values of the dividends and capital appreciation, past yields are used
to denote the cost of capital. This approach is based upon the assumption that
the past behaviour would be repeated in future and thus, they may be used to
measure the cost of ordinary capital.

Which approach to use ? In case of companies with stable income and stable
dividend policies the D/P approach may be a good way of measuring the cost of
ordinary share capital. In case of companies whose earnings accrue in cycles, it
would be better if the E/P approach is used, but representative figures should be
taken into account to include complete cycle. In case of growth companies,
where expectations of growth are more important, cost of ordinary share capital
may be determined as the basis of the D/P + g approach. In the case of
companies enjoying a steady growth rate and a steady rate of dividend, the
realised value approach may be useful. The basic factor behind determination of
cost of ordinary share capital is to measure expectation of investors from
ordinary shares of that particular company. Thus, the whole question of
determining the cost of ordinary shares hinges upon the factors which go into the
expectations of a particular group of investors in the company of a particular risk
class.

4) cost of reserves : The profits retained by a company and used in the

expansion of business also entail cost. Many people tend to feel that reserves
have no cost. However, it is not easy to realised that by depriving the
shareholders of a part of the earnings, a cost is automatically incurred on
reserves. This may be termed as the opportunity cost of retained earnings.
Suppose, these earnings are not retained and are passed on to shareholders,
suppose further that shareholders invest the same in new ordinary shares. This
expectation of the investors from new ordinary shares should be the opportunity
cost of reserves. In other words, if earnings were paid out as dividends and
simultaneously an offer for right shares was made shareholders would have
subscribed to the right share on the expectation of a certain return. This return
may be taken as the indicator of the cost of reserves. People do not calculate
the cost of capital of retained earnings as above. They take cost of retained
earnings as the same as that of equity shares. However, if the cost of equity
shares is determined on the basis of realised value approach or D/P + g
approach, the question of working out a separate cost of reserves is not relevant
since cost of reserves is automatically included in the cost of equity share
capital.

5) Cost of depreciation funds : Depreciation funds, cannot be construed as not

having any cost. Logically speaking, they should be treated on the same footing
as reserves when it comes to their use, though while calculating the cost of
capital these funds may not be considered.

Question : Enumerate the procedure of calculating the weighted average

cost of capital ?

Answer : The composite or overall cost of capital of a firm is the weighted

average of the costs of various sources of funds. Weights are taken to be
proportion of each source of funds in the capital structure. While, making
financial decisions this overall or weighted cost is used. Each investment is
financed from a pool of funds which represents the various sources from which
funds have been raised. Any decision of investment thus, has to be made with
reference to the overall cost of capital and not with reference to cost of a
specific source of fund used in that investment decisions. The weighted average
cost of capital (WACC) is calculated by :
1) Calculating cost of specific sources of funds, e.g. cost of debt, etc.
2) Multiplying the cost of each source by its proportion in capital structure.
3) Adding the weighted component costs to get the firm's WACC. Thus, WACC
is ,

K 0 = K 1 W 1 + K 2 W 2 +.............
Where,
K 1 , K 2 are component costs and W 1 , W 2 are weights.

The weights to be used can be either book value weights or market value
weights. Book value weights are easier to calculate and can be applied
consistently. Market value weights are supposed to be superior to book value
weights as component costs are opportunity costs and market values reflect
economic values. However, these weights fluctuate frequently and fluctuations
are wide in nature.

Question : What do you mean by marginal cost of capital ?

Answer : The marginal cost of capital may be defined as the cost of raising an
additional rupee of capital. Since the capital is raised in substantial amount in
practice marginal cost is referred to as the cost incurred in raising new funds.
Marginal cost of capital is derived, when we calculate the average cost of capital
using the marginal weights. The marginal weights represent the proportion of
funds the firm intends to employ. Thus, the problem of choosing between the
book value weights and the market value weights does not arise in the case of
marginal cost of capital computation. To calculate the marginal cost of capital,
the intended financing proportion should be applied as weights to marginal
component costs. The marginal cost of capital should, thus, be calculated in the
composite sense. When a firm raises funds in proportional manner and the
component's cost remain unchanged, there will be no difference between
average cost of capital of total funds and the marginal cost of capital. The
component's cost may remain unchanged, upto a certain level of funds raised
and then start increasing with amount of funds raised, e.g. The cost of debt
remains 7 % after tax till Rs. 10 lakhs and between Rs. 10 - 15 lakhs, the cost
may be 8 % and so on. Similarly, if the firm has to use the external equity when
the retained profits are not sufficient, the cost of equity will be higher because of
flotation costs. When the components cost starts rising, the average cost of
capital would rise and marginal cost of capital would however, rise at a faster
rate.

Question : What is the effect of a financing decision on EPS ?

Answer : One of the prime objective of a finance manager is to maximise both
the return on ordinary shares and the total wealth of the company. This objective
has to be kept in view while, taking a decision on a new source of finance. Thus,
the effect of each proposed method of new finance on the EPS is to be carefully
analysed. EPS denotes what has been earned by the company during a
particular accounting period, on each of its ordinary shares. This can be worked
out by dividing net profit after interest, taxes and preference dividends by the
number of equity shares. If a company has a number of alternatives for new
financing, it can compute the impact of the various alternatives on earnings per
share. It is obvious that, EPS would be the highest in case of financing that has
the least cost to the company.

1) Explicit cost of new capital : It is a method that can compare the

alternatives available for raising capital can be through the calculation of the
explicit cost of new capital. Explicit cost of new capital is the rate of return at
which the new funds must be employed so that the existing EPS is not affected.
In other words, the rate of return of new funds must earn to maintain EPS at the
existing levels. It is obvious that, if EPS were Rs. 2 earlier, the rate of return
required to be earned by the source of new capital to maintain it at the old level
is to be found. Long term debt would again be preferred as even if a lower rate
of return is earned on the funds so raised, the old EPS will be maintained.

2) Range of earnings chart/Indifference point : Another method of considering

the impact of various financing alternatives on EPS is to prepare the EBIT chart
or the range of earnings chart. It shows the likely EPS at various probable EBIT
levels. Thus, under one particular alternative, EPS may be Rs. 1 at a given EBIT
level. However, the EPS may reduce if another alternative of financing is chosen
even though the EBIT under the alternative may be drawn. Wherever this line
intersects, it is known as break - even point. This point is a useful guide in
formulating the capital structure. This is known as EPS equivalency point or
indifference point as, it shows that, between the 2 given alternatives of financing
i.e. regardless of leverage in financial plans, EPS would be the same at the
given EBIT level. The equivalency or indifference point can also be calculated
algebraically as below :

[X - B]/S 1 = X/S 2
Where,
X = Indifference point (EBIT)
S 1 = Number of equity shares outstanding
S 2 = Number of equity shares outstanding when only equity capital is used.
B = Interest on debt capital in rupees.

3) EPS Volatility : EPS Volatility refers to the magnitude or extent of

fluctuations in EPS of a company in various years as compared to the mean or
average EPS. In other words, EPS volatility shows whether a company enjoys a
stable income or not. It is obvious that higher the EPS Volatility, greater would
be the risk attached to the company. A major cause of EPS Volatility would be
the fluctuations in the sales volume and the operating leverage. It is obvious that
the net profits of a company would greatly fluctuate with small fluctuations in the
sales figures specially if the fixed cost content is very high. Thus, EPS will
fluctuate in such a situation. This effect may be heightened by the financial
leverage.

CHAPTER SEVEN

SOURCES OF FINANCE

Question : List down the financial needs and the sources available with a
business entity to satisfy such needs ?

Answer : One of the most important consideration for an entrepreneur-company

in implementing a new project or undertaking expansion, diversification,
modernisation and rehabilitation scheme is ascertaining the cost of project and
the means of finance. There are several sources of finance/funds available to
any company. An effective appraisal mechanism of various sources of funds
available to a company must be instituted in the company to achieve its main
objectives. Such a mechanism is required to evaluate risk, tenure and cost of
each and every source of fund. This selection of fund source is dependent on the
financial strategy pursued by the company, the leverage planned by the
company, the financial conditions prevalent in the economy & the risk profile of
both i.e. the company and the industry in which the company operates. Each and
every source of fund has some advantages and disadvantages.

I) Financial needs of a business are grouped as follows :

1) Long term financial needs : Such needs generally refer to those

requirements of funds which are for a period exceeding 5 - 10 years. All
investments in plant and machinery, land, buildings, etc. are considered as long
term financial needs. Funds required to finance permanent or hard core working
capital should also be procured from long term sources.

2) Medium term financial needs : Such requirements refer to those funds

which are required for a period exceeding one year but not exceeding 5 years.
Funds required for deferred revenue expenditure (i.e benefit of expense expires
after a period of 3 to 5 years), are classified as medium term financial needs.
Sometimes long term requirements, for which long term funds cannot be
arranged immediately may be met from medium term sources and thus the
demand of medium term financial needs are generated, as and when the desired
long-term funds are available medium term loan may be paid off.
3) Short term financial needs : Such type of financial needs arise for financing
current assets as, stock, debtors, cash, etc. Investment in these assets is known
as meeting of working capital requirements of the concern. Firms require working
capital to employ fixed assets gainfully. The requirement of working capital
depends on a number of factors that may differ from industry to industry and
from company to company in the same industry. The main characteristic of short
term financial needs is that they arise for a short period of time not exceeding
the accounting period i.e. one year.

The basic principle for categorising the financial needs into short term,
medium term and long term is that they are met from the corresponding viz. short
term, medium term and long term sources respectively. Accordingly the source of
financing is decided with reference to the period for which funds are required.
Basically, there are 2 sources of raising funds for any business enterprise viz.
owners capital and borrowed capital. The owners capital is used for meeting long
term financial needs and it primarily comes from share capital and retained
earnings. Borrowed capital for all other types of requirement can be raised from
different sources as debentures, public deposits, financial institutions,
commercial banks, etc.

II) Sources of finance of a business are :

1) Long term :
i) Share capital or Equity share capital
ii) Preference shares
iii) Retained earnings
iv) Debentures/Bonds of different types
v) Loans from financial institutions
vi) Loans from State Financial Corporation
vii) Loans from commercial banks
viii) Venture capital funding
ix) Asset securitisation
x) International financing like Euro-issues, Foreign currency loans.

2) Medium term :
i) Preference shares
ii) Debentures/Bonds
iii) Public deposits /fixed deposits for a duration of 3 years
iv) Commercial banks
v) Financial institutions
vi) State financial corporations
vii) Lease financing/Hire-purchase financing
viii) External commercial borrowings
ix) Euro-issues
x) Foreign currency bonds.

3) Short-term :
i) Trade credit
ii) Commercial banks
iii) Fixed deposits for a period of 1 year or less
iv) Advances received from customers
v) Various short-term provisions

III) Financial sources of a business can also be classified as follows on

using different basis :

1) According to period :
i) Long term sources
ii) Medium term sources
iii) Short term sources

2) According to ownership :
i) Owners capital or equity capital, retained earnings, etc.
ii) Borrowed capital such as, debentures, public deposits, loans, etc.

3) According to source of generation :

i) Internal sources e.g. retained earnings and depreciation funds, etc.
ii) External sources e.g. debentures, loans, etc.

However, for convenience, the different sources of funds can also be

classified into the following :
a) Security financing - financing through shares and debentures
b) Internal financing - financing through retained earning, depreciation
c) Loans financing - this includes both short term and long term loans
d) International financing
e) Other sources.

Question : Write a note on long term sources of finance.

Answer : There are different sources of funds available to meet long term
financial needs of the business. These sources may be broadly classified into
share capital (both equity and preference) and debt (including debentures, long
term borrowings or other debt instruments). In India, many companies have
raised long term finance by offering various instruments to public like deep
discount bonds, fully convertible debentures, etc. These new instruments have
characteristics of both equity and debt and it is difficult to categorise them into
equity and debt. Different sources of long term finance are :

1) Owners' capital or equity capital :

A public limited company may raise funds from promoters or from the
investing public by way of owners capital or equity capital by issuing ordinary
equity shares. Ordinary shareholders are owners of the company and they
undertake risks of business. They elect the directors to run the company and
have the optimum control over the management of the company. Since equity
shares can be paid off only in the event in liquidation, this source has the least
risk involved, and more due to the fact that the equity shareholders can be paid
dividends only when there are distributable profits. However, the cost of ordinary
shares is usually the highest. This is due to the fact that such shareholders
expect a higher rate of return on their investments compared to other suppliers
of long term funds. The dividend payable on shares is an appropriation of profits
and not a charge against profits, meaning that it has to be paid only out of
profits after tax. Ordinary share capital also provides a security to other
suppliers of funds. Thus, a company having substantial ordinary share capital
may find it easier to raise funds, in view of the fact that the share capital
provides a security to other suppliers of funds. The Companies Act, 1956 and
SEBI Guidelines for disclosure and investors' protections and the clarifications
thereto lays down a number of provisions regarding the issue and management
of equity share capital.

Advantages of raising funds by issue of equity shares are :

i) It is a permanent source of finance.

ii) The issue of new equity shares increases the company's flexibility.

iii) The company can make further issue of share capital by making a right issue.

iv) There is no mandatory payments to shareholders of equity shares.

2) Preference share capital :

These are special kind of shares, the holders of which enjoy priority in
both, repayment of capital at the time of winding up of the company and payment
of fixed dividend. Long-term funds from preference shares can be raised through
a public issue of shares. Such shares are normally cumulative, i.e. the dividend
payable in a year of loss gets carried over to the next till, there are adequate
profits to pay cumulative dividends. Rate of dividend on preference shares is
normally higher than the rate of interest on debentures, loans, etc. Most of
preference shares now a days carry a stipulation of period and the funds have to
be repaid at the end of a stipulated period. Preference share capital is a hybrid
form of financing that partakes some characteristics of equity capital and some
attributes of debt capital. It is similar to equity because preference dividend, like
equity dividend is not a tax deductible payment. It resembles debt capital as the
rate of preference dividend is fixed. When preference dividend is skipped, it is
payable in future due to the cumulative feature associated with most of
preference shares. Cumulative Convertible Preference Shares (CCPs) may also
be offered, under which the shares would carry a cumulative dividend of
specified limit for a period of say 3 years, after which the shares are converted
into equity shares. These shares are attractive for projects with a long gestation
period. For normal preference shares, the maximum permissible rate of dividend
is 14 %. Preference share capital may be redeemed at a predecided future date
or at an earlier stage inter alia out of the company's profits. This enables the
promoters to withdraw their capital from the company which is now self-
sufficient, and the withdrawn capital may be reinvested in other profitable
ventures. Irredeemable preference shares cannot be issued by any company.
Preference shares gained importance after the Finance Bill 1997 as dividends
became tax exempted in the hands of the individual investor and are taxable in
the hands of the company as tax is imposed on distributable profits at a flat rate.
The Budget, for 2000 - 01 has doubled the dividend tax from 10 % to 20 %
besides a surcharge of 10 %. The budget for 2001 - 2002 has reduced the
dividend tax from 20 to 10 %. Many companies followed this route during 1997
especially through private placement or preference shares as the capital markets
were not vibrant.

The advantages of taking the preference share capital are as follows :

1) No dilution in EPS on enlarged capital base : If equity is issued it reduces

EPS, thus affecting the market perception about the company.

2) There is leveraging advantage as it bears a fixed charge.

3) There is no risk of takeover.

4) There is no dilution of managerial control.

5) Preference capital can be redeemed after a specified period.

3) Retained Earnings :
Long term funds may also be provided by accumulation of company's
profits and on ploughing them back into business. Such funds belong to the
ordinary shareholders and increases the company's net worth. A public limited
company must plough back a reasonable amount of profit every year, keeping in
view the legal requirements in this regard, and its own expansion plans. Such
funds entail almost no risk and the present owner's control is maintained as
there is no dilution of control.
4) Debentures or bonds :
Loans can be raised from public on issue of debentures or bonds by
public limited companies. Debentures are normally issued in different
denominations ranging from Rs. 100 to 1000 and carry different rates of interest.
On issue of debentures, a company can raise long term loans from public.
Usually, debentures are issued on the basis of a debenture trust deed which lists
terms and conditions on which debentures are floated. They are normally
secured against the company's assets. As compared with preference shares,
debentures provide a more convenient mode of long term funds. Cost of capital
raised through debentures is low as the interest can be charged as an expense
before tax. From the investors' view point, debentures offer a more attractive
prospect than preference shares as interest on debentures is payable whether or
not the company makes profits. Debentures are thus, instruments for raising long
term debt capital. Secured debentures are protected by a charge on the
company's assets. While the secured debentures of a well-established company
may be attractive to investors, secured debentures of a new company do not
normally evoke same interest in the investing public.

Advantages :

1) The cost of debentures is much lower than the cost of preference or equity
capital as the interest is tax-deductible. Also, investors consider debenture
investment safer than equity or preferred investment and thus, may require a
lower return on debenture investment.

2) Debenture financing does not result in dilution of control.

3) In a period of rising prices, debenture issue is advantageous. The fixed

monetary outgo decreases in real terms as the price level increases.

Disadvantages of debenture financing are as below :

1) Debenture interest and capital repayment are obligatory payments.

2) The protective covenants associated with a debenture issue may be

restrictive.

3) Debentures financing enhances the financial risk associated with the firm.

These days many companies are issuing convertible debentures or

bonds with a number of schemes/incentives like warrants/options, etc. These
bonds or debentures are exchangeable at the ordinary share holder's option
under specified terms and conditions. Thus, for the first few years these
securities remain as debentures and later they can be converted into equity
shares at a pre-determined conversion price. The issue of convertible
debentures has distinct advantages from the view point of the issuing company.
- such as issue enables the management to raise equity capital indirectly without
diluting the equity holding, until the capital raised starts earning an added return
to support additional shares.

- such securities can be issued even when the equity market is not very good.

- convertible bonds are normally unsecured and, thus, their issuance may
ordinarily not impair the borrowing capacity.

These debentures/bonds are issued subject to the SEBI guidelines

notified from time to time. Public issue of debentures and private placement to
mutual funds, require that the issue be rated by a credit rating agency as CRISIL
(Credit Rating and Information Services of India Ltd.). The credit rating is given
after evaluating factors as track record of the company, profitability, debt service
capacity, credit worthiness and the perceived risk of lending.

5) Loans from financial institutions :

In India specialised institutions provide long-term financial assistance
to industries. Some of them are, Industrial Finance Corporations, Life Insurance
Corporation of India, National Small Industries Corporation Limited, Industrial
Credit and Investment Corporation, Industrial Development Bank of India and
Industrial Reconstruction Corporation of India. Before sanctioning of a term loan,
a company has to satisfy the concerned financial institution regarding the
technical, commercial, economic, financial and managerial viability of the project
for which the loan is required. Such loans are available at different rates of
interest under different schemes of financial institutions and are to be repaid as
per a stipulated repayment schedule. The loans in many cases stipulate a
number of conditions as regards the management and certain other financial
policies of the company. Term loans represent secured borrowings and are an
important source of funds for new projects. They generally, carry a rate of
interest inclusive of interest tax, depending on the credit rating of the borrower,
the perceived risk of lending and cost of funds and generally repayable over a
period of 6 to 10 years in annual, semi-annual or quarterly installments. Term
loans are also provided by banks, State Financial/Development institutions and
all India term lending financial institutions. Banks and State Financial
Corporations provide term loans to projects in the small scale sector while, for
medium and large industries term loans are provided by State developmental
institutions alone or in consortium with banks and State financial corporations.
For large scale projects All India financial institutions provide bulk of term
finance singly or in consortium with other such institutions, State level
institutions and/or banks. After independence, the institutional set up in India for
the provision of medium and long term credit for industry has been broadened.
The assistance sanctioned and disbursed by these specialised institutions has
increased impressively over the years. A number of specialised institutions are
established over the country.

6) Loans from commercial banks :

The primary role of the commercial banks is to cater to the short term
requirement of industry. However, of late, banks have started taking an interest
in term financing of industries in several ways, though the formal term lending is,
still, small and confined to major banks. Terms lendings by bank is a
controversial issue these days. It is argued that term loans do not satisfy the
canon of liquidity that is a major consideration in all bank operations. According
to traditional values, banks should provide loans only for short periods and
operations resulting in automatic liquidation of such credits over short periods.
On the other hand, it is contended that the traditional concept needs
modification. The proceeds of term loan are used for what are broadly known as
fixed assets or expansion in plant capacity. Their repayment is usually scheduled
over a long period of time. The liquidity of such loans is said to depend on the
anticipated income of borrowers.

Working capital loan is more permanent and long term as compared to

a term loan. The reason being that a term loan is always repayable on a fixed
date and ultimately, the account will be totally adjusted. However, in case of
working capital finance, though payable on demand, in actual practice it is
noticed that the account is never adjusted as such and if at all the payment is
asked back, it is with a clear purpose and intention of refinance being provided
at the beginning of next year or half year. This technique of providing long term
finance is known as, "rolled over for periods exceeding more than one year".
Instead of indulging in term financing by the rolled over method, banks can and
should extend credit term after a proper appraisal of applications for term loans.
The degree of liquidity in the provision for regular amortisation of term loans is
more than in some of these so called demand loans which are renewed from year
to year. Actually, term financing, disciplines both the banker and borrower as
long term planning is required to ensure that cash inflows would be adequate to
meet the instruments of repayments and allow an active turnover of bank loans.
The adoption of the formal term loan lending by commercial banks will not
hamper the criteria of liquidity, and will introduce flexibility in the operations of
the banking system.

The real limitation to the scope of bank activities is that all banks are
not well equipped to appraise such loan proposals. Term loan proposals involve
an element of risk because of changes in conditions affecting the borrower. The
bank making such a loan, thus, has to assess the situation to make a proper
appraisal. The decision in such cases depends on various factors affecting the
concerned industry's conditions and borrower's earning potential.

7) Bridge finance :
 It refers to loans taken by a company from commercial banks for a short
period, pending disbursement of loans sanctioned by financial institutions.
Normally, it takes time for financial institutions to disburse loans to companies.
However, loans once approved by the term lending institutions pending the
signing of regular term loan agreement, that may be delayed due to non-
compliance of conditions stipulated by the institutions while sanctioning the loan.
The bridge loans are repaid/adjusted out of term loans as and when disbursed by
the concerned institutions. They are secured by hypothecating movable assets,
personal guarantees and demand promissory notes. Generally, the interest rate
on them is higher than on term loans.

Question : What do you mean by Venture Capital Financing ?

Answer : Venture capital financing refers to financing of new high risky venture
promoted by qualified entrepreneurs lacking experience and funds to give shape
to their ideas. Under it venture capitalist make investment to purchase equity or
debt securities from inexperienced entrepreneurs undertaking highly risky
ventures with a potential of success. The venture capital industry in India is just
a decade old. The venture capitalist finance ventures that are in national priority
areas such as energy conservation, quality upgradation, etc. The Government of
India in November 1988 issued the first set of guidelines for venture capital
companies, funds and made them eligible for capital gain concessions. In 1995,
certain new clauses and amendments were made in the guidelines that require
the venture capitalists to meet the requirements of different statutory bodies and
this makes it difficult for them to operate as they do not have much flexibility in
structuring investments. In 1999, the existing guidelines were relaxed for
increasing the attractiveness of the venture schemes and to induce high net
worth investors to commit their funds to 'sunrise' sectors, particularly the
information technology sector. Initially the contribution to the funds available for
venture capital investment in the country was from the All India development
financial institutions, State development financial institutions, commercial banks
and companies in private sector. Lately many offshore funds have been started
in the country and maximum contribution is from foreign institutional investors. A
few venture capital companies operate as both investment and fund management
companies, other set up funds and function as asset management company. It is
hoped that changes in the guidelines for implementation of venture capital
schemes in the country would encourage more funds to be set up to give the
required momentum for venture capital investment in India. Some common
methods of venture capital financing are :
1) Equity financing : The venture capital undertakings usually require funds for
a longer period but, may not be able to provide returns to investors during the
initial stages. Thus, the venture capital finance is generally provided by way of
equity share capital. The equity contribution of venture capital firm does not
exceed 49 % of the total equity capital of venture capital undertakings so that
the effective control and ownership remains with the entrepreneur.

2) Conditional loan : It is repayable in the form of a royalty after the venture is

able to generate sales. No interest is paid on such loans. In India venture capital
financers charge royalty ranging between 2 and 15 %, actual rate depends on
other factors of the venture as gestation period, cash flow patterns, riskiness
and other factors of the enterprise. Some venture capital financers give a choice
to the enterprise of paying a high rate of interest, which can be well below 20
%, instead of royalty on sales once it becomes commercially sounds.

3) Income note : It is a hybrid security combining features of both conventional

and conditional loan. The entrepreneur has to pay interest and royalty on sales
but, at substantially low rates. IDBI's Venture Capital Fund (VCF) provides
funding equal to 80 - 87.5 % of the project cost for commercial application of
indigenous technology.

4) Participating debentures : Such security carries charges in 3 phases - in the

start up phase no interest is charged, next stage - a low rate of interest is
charged upto a particular level of operation and after that, a high rate of interest
is required to be paid.

Question : Write a note on Debt Securitisation ?

Answer : Debt securitisation is a method of recycling of funds. It is especially

beneficial to financial intermediaries to support the lending volumes. Assets
generating steady cash flows are packaged together and against this asset pool
market securities can be issued. The basic debt securitisation process can be
classified in the following 3 functions :

1) The origination function : A borrower seeks a loan from a finance company,

bank, housing company or a lease from a leasing company. The creditworthiness
of the borrower is evaluated and a contract is entered into with repayment
schedule structured over the life of the loan.

2) The pooling function : Similar loans or receivables are clubbed together to

create an underlying pool of assets. This pool is transferred in favour of a SPV
(Special Purpose Vehicle), which acts as a trustee for the investor. Once the
assets are transferred, they are held in the originators' portfolio.

3) The securitisation function : It is the SPV's job now to structure and issue
the securities on the basis of the asset pool. The securities carry a coupon and
an expected maturity which can be asset based or mortgage based. These are
generally sold to investors through merchant bankers. The investors interested
in this type of securities are generally institutional investors like mutual funds,
insurance companies, etc. The originator usually keeps the spread available i.e.
difference between yield from secured assets and interest paid to investors. The
process of securitisation is generally without recourse i.e. the investor bears the
credit risk or risk of default and the issuer is under an obligation to pay to
investors only if the cash flows are received by him from the collateral. The risk
run by the investor can be further reduced through credit enhancement facilities
as insurance, letters of credit and guarantees. In a simple pass through
structure, the investor owns a proportionate share of the asset pool and cash
flows when generated are passed on directly to the investor. This is done by
issuing pass through certificates. In mortgage or asset backed bonds, the
investor has a lien on the underlying asset pool. The SPV accumulates payments
from borrowers from time to time and make payments to investors at regular
predetermined intervals. The SPV can invest the funds received in short term
instruments and improve yield when there is a time lag between receipt and
payment.

Benefits to the originator :

1) The assets are shifted off the balance sheet, thus, giving the originator
recourse to off balance sheet funding.

2) It converts illiquid assets to liquid portfolio.

3) It facilitates better balance sheet management as assets are transferred off

balance sheet facilitating satisfaction of capital adequacy norms.

4) The originator's credit rating enhances.

For the investor, securitisation opens up new investment avenues. Though the
investor bears the credit risk. The securities are tied up to definite assets. As
compared to factoring or bill discounting which largely solve the problems of
short term trade financing. Securitisation helps to convert a stream of cash
receivables into a source of long term finance. For a developed securitisation
market, high quality assets with low default rate are essential with standardised
loan documentation and stable interest rate structure and sufficient data on
asset performance, developed secondary debt markets are essential for this. In
Indian context debt securitisation has began to take off. The ideal candidates for
this are hire purchase and leasing companies, asset finance and real estate
finance companies. ICICI, HDFC, Citibank, Bank of America, etc. have or are
planning to raise funds by securitisation.

Question : Explain briefly the term Lease Financing ?

Answer : Leasing is a general contract between the owner and user of the asset
over a specified period of time. The asset is purchased initially by the lessor
(leasing company) and thereafter leased to the user (lessee company) that pays
a specified rent at periodical intervals. Thus, leasing is an alternative to the
purchase of an asset out of own or borrowed funds. Moreover, lease financing
can be arranged much faster as compared to term loans from financial
institutions. In recent years, leasing has become a popular source of financing in
India. From the lessee's view point, leasing has the attraction of eliminating
immediate cash outflow and the lease rentals can be deducted for computing the
total income under the Income tax act. As against this, buying has the
advantages of depreciation allowance inclusive of additional depreciation and
interest on borrowed capital being tax deductible. Thus, an evaluation of the 2
alternatives is to be made in order to take a decision.

Question : Explain the various sources of short term finance ?

Answer : Following are the various sources of short term finance :

1) Trade credit : It represents credit granted by suppliers of goods, etc. as an

incident of sale. The usual duration of such credit is 15 to 90 days. It generates
automatically, in the course of business and is common to almost all business
operations. It can be in the form of an 'open account' or 'bills payable'. Trade
credit is preferred as a source of finance as it is without any explicit cost and till
a business is a going concern, it keeps on rotating. It also, enhances
automatically with the increase in the volume of business.

2) Advances from customers : Manufacturers and contractors engaged in

producing or constructing costly goods involving considerable length of
manufacturing or construction time usually, demand advance money from their
customers at the time of accepting their orders for executing their contracts or
supplying the goods. This is a cost free source of finance and really useful.

3) Bank advances :
Banks receive deposits from public for different periods at varying
rates of interest there are funds invested and lent in such a manner that when
required, they may be called back. Lending results in gross revenues out of
which costs, such as interest on deposits, administrative costs, etc. are met and
a reasonable profit is made. A bank's lending policy is not merely profit
motivated but has to keep in mind the socio-economic development of the
country. As a prudent policy, banks normally spread out their funds as under :

i) About 9 - 10 % in cash.

ii) About 32 % in approved government and semi-government securities.

iii) About 58 % in advances to their credits.

Banks advances are in the form of loan, overdraft, cash credit and bills
purchased/discounted, etc. Banks do not sanction advances on long term basis
beyond a small proportion of their demand and time liabilities. Advances are
granted against tangible securities such as goods, shares, government
promissory notes, bills, etc. In rare cases, clean advances may also be allowed.

a) Loans : In a loan account, the entire advance is disbursed at one time in cash
or by transfer to the current account of the borrower. It is a single advance,
except by way of interest and other charges, no further adjustments are made in
this account. Loan accounts are not running accounts like overdraft and cash
credit accounts, repayment under the loan account, may be full amounts or by
way of schedule of repayments agreed upon as in case of terms loans. The
securities may be shares, government securities, life insurance policies and
fixed deposit receipts and so on.

b) Overdrafts : Under this facility, customers are allowed to withdraw in excess

of credit balance standing in their current deposit account. A fixed limit is thus,
granted to the borrower within which the borrower is allowed to overdraw his
account. Opening of an overdraft account requires that a current account is
formally opened. Although overdrafts are repayable on demand, they usually
continue for long periods by annual renewals of limits. This is a convenient
arrangement for the borrower, as he is in a position to avail the sanctioned limit
as per his requirements. Interest is charged on daily balances, cheque books are
provided, these accounts being operative as cash credit and current accounts.
Security, as in case of loan accounts, may be shares, debentures and
government securities, life insurance policies and fixed deposit receipts are also
accepted in special cases.
c) Clean overdrafts : Request for such facility is entertained only from
financially sound parties that are reputed for their integrity. Bank is to rely on
personal security of the borrowers, thus, it has to exercise a good deal of
restraint in entertaining such proposals, as they have no backing of any tangible
security. In case parties are already enjoying secured advance facilities, this
may be a point in favour and may be taken into account while screening such
proposals. The turnover in the account, satisfactory dealings for considerable
period and reputation in the market are also considered by the bank. As a
safeguard, banks take guarantees from other persons who are credit worthy
before granting this facility. A clean advance is generally granted for a short
period and must not be continued for long.

d) Cash credits : Cash credit is an arrangement under which, a customer is

allowed an advance upto certain limit against credit granted by bank. Under it, a
customer need not borrow, the entire amount of advance at one time. He can
only draw to the extent of his requirements and deposit his surplus funds in his
account. Interest is not charged on the full amount of advance but, on the
amount actually availed by him. Usually, credit limits are sanctioned against the
security of goods by way of pledge or hypothecation, though they are repayable
on demand, banks usually do not recall them, unless they are compelled to do so
by adverse factors. Hypothecation is an equitable charge on movable goods for
an amount of debt where neither possession nor ownership is passed on to the
creditor. For pledge, the borrower delivers the goods to the creditor as security
for repayment of debt. Since the banker, as creditor, is in possession of the
goods, he is fully secured and in case of emergency he may fall back on the
goods for realisation of his advance under proper notice to the borrower.

e) Advances against goods : Advances against goods occupy an important

place in total bank credit, goods as security have certain distinct advantages :

- they provide a reliable source of repayment

- advances against goods are safe and liquid

Generally, goods are charged to the bank by way of pledge or

hypothecation. The term 'goods' includes all forms of movables that are offered
to the bank as security. They may be agricultural commodities, industrial raw
materials, partly finished goods and so on. RBI issues directives from time to
time imposing restrictions on advances against certain commodities. It is
obligatory on banks to follow these directives in letter and spirit, they may
sometimes, also stipulate changes in margin.

f) Bills purchased/discounted : These advances are allowed against the

security of bills that may be clean or documentary. Bills are sometimes,
purchased from approved customer, in whose favour limits are sanctioned.
Before granting a limit, the banker satisfies himself as to the creditworthiness of
the drawer. Although the term 'bills purchased' gives the impression that the
bank becomes the owner or purchaser of such bills, in reality, the bank holds the
bills as security only, for the advance. In addition to the rights against the
parties liable on the bills, the banks can also exercise a pledgee's rights over
the goods covered by the documents. Usuance bills maturing at a future date or
sight are discounted by the banks for approved parties. When a bill is
discounted, the borrower is paid the present worth. The bankers, however,
collect the full amounts on maturity, the difference between the 2 i.e. the amount
of the bill and the discounted amount represents earnings of bankers for the
period; it is termed as 'discount'. Sometimes, overdraft or cash credit limits are
allowed against the security of bills. A suitable margin is usually maintained.
Here the bill is not a primary security but, only a collateral one. In such case,
the banker does not become a party to the bill, but merely collects it as an agent
for its customer. When a banker purchases or discounts a bill, he advances
against the bill, he thus, has to be very cautious and grant such facilities only to
creditworthy customers, having an established steady relationship with the bank.
Credit reports are also complied on the drawees.

g) Advance against documents of title to goods : A document becomes of

document of title to goods when its possession is recognised by law or business
custom as possession of the goods. These documents include a bill of lading,
dock warehouse keeper's certificate, railway receipt, etc. A person in possession
of a document to goods can by endorsement or delivery or both of document,
enables another person to take delivery of the goods in his right. An advance
against pledge of such documents is equivalent to an advance against the
pledge of goods themselves.

h) Advance against supply of bills : Advances against bills for supply of goods
to government or semi-government departments against firm orders after
acceptance of tender fall under this category. Other type of bills under this
category are bills from contractors for work executed wholly or partially under
firm contracts entered into with the herein mentioned government agencies.
These are clean bills, without being accompanied by any document of title of
goods. But, they evidence supply of goods directly to Governmental agencies.
They may, sometimes, be accompanied by inspection notes from representatives
of government agencies for inspecting the goods before despatch. If bills are
without inspection report, banks like to examine them with the accepted tender
or contract for verifying that the goods supplied under the bills strictly conform
to the terms and conditions in the acceptance tender. These supply bills
represent debt in favour of suppliers/contractors, for goods supplied to
government bodies or work executed under contract from the Government
bodies. This debt is assigned to the bank by endorsement of supply bills and
executing irrevocable power of attorney in favour of banks for receiving the
amount of supply bills from the Government departments. The power of attorney
has got to be registered with the department concerned. The banks also take
separate letter from the suppliers/contractors instructing the Government body to
pay the amount of bills direct to the bank. Supply bills do not enjoy the legal
status of negotiable instruments as they are not bills of exchange. The security
available to a banker is by way of assignment of debts represented by the
supply bills.

i) Term loans by banks : It is an instalment credit repayable over a period of

time in monthly/quarterly/half-yearly or yearly instalments. Banks grant term
loans for small projects falling under the priority sector, small scale sector and
big units. Banks have now been permitted to sanction term loan for projects as
well without association of financial institutions. The banks grant loans for
periods normally ranging from 3 to 7 years and at times even more. These loans
are granted on the security of fixed assets.

j) Financing of exports by banks : Advances by commercial banks for export

financing are in the form of :

a) Pre-shipment finance i.e. before shipment of goods : This usually, takes

the form of packing credit facility, which is an advance extended by banks to an
exporter for the purpose of buying, manufacturing, processing, packing, shipping
goods to overseas buyers. Any exporter, having at hand a firm export order
placed with him by his foreign buyer or an irrevocable letter of credit opened in
his favour, can approach a bank for availing packing credit. An advance so taken
requires to be liquidated within 180 days from the date of its commencement by
negotiation of export proceeds in an approved manner. Thus, packing credit is
essentially a short term advance. Usually, banks insist on their customers to
lodge with them irrevocable letters of credit opened in favour of the customers
by overseas buyers. The letter of credit and firm sale contracts not only serve as
evidence of a definite arrangement for realisation of the export proceeds but
also indicate the amount of finance required by the exporter. Packing credit in
case of customers of long standing, may also be granted against firm contracts
entered into by them with overseas buyers. Following are the types of packing
credit available :

i) Clean packing credit : This is an advance available to an exporter only on

production of a firm export order or a letter of credit without exercising any
charge or control over raw material or finished goods. Each proposal is weighted
according to particular requirements of trade and credit worthiness of the
exporter. A suitable margin has to be maintained. Also, Export Credit Guarantee
Corporation (E.C.G.C.) cover should be obtained by the bank.

ii) Packing credit against hypothecation of goods : Export finance is made

available on certain terms and conditions where the exporter has pledgeable
interest and the goods are hypothecated to the bank as security with stipulated
margin. At the time of utilising the advance, the exporter is required to submit,
along with the firm export order or letter of credit, relative stock statements and
thereafter continue submitting them every fortnight and/or whenever there is any
movement in stocks.

iii) Packing credit against pledge of goods : Export finance is made available
on certain terms and conditions where the exportable finished goods are pledged
to the banks with approved clearing agents who would ship the same from time
to time as required by the exporter. Possession of goods so pledged lies with the
bank and are kept under its lock and key.

iv) E.C.G.C. guarantee : Any loan given to an exporter for the manufacture,
processing, purchasing or packing of goods meant for export against a firm order
qualifies for packing. Credit guarantee is issued by the Export Credit Guarantee
Corporation (E.C.G.C.).

v) Forward exchange contract : Another requirement of packing credit facility is

that if the export bill is to be drawn in a foreign currency, the exporter should
enter into a forward exchange contract with the bank, thereby avoiding risk
involved in a possible change in the exchange rate.

Documents required :
- In case of partnership firms, banks usually require the following documents :
Joint and several demand pronote signed on behalf of the firm as also by
partners individually;
Letter of continuity, signed on behalf of the firm and partners individually;
Letter of pledge to secure demand cash credit against stock, in case of
pledge or agreement of
hypothecation to secure demand cash credit, in case of hypothecation.
Letter of authority to operate the account;
Declaration of Partnership, in case of sole traders, sole proprietorship
declaration;
Agreement to utilise the monies drawn in terms of contract;
Letter of hypothecation for bills.
- Following documents are required by banks, in case of limited companies :
Demand pro-note;
Letter of continuity;
Agreement of hypothecation of letter of pledge, signed on behalf of the
company;
General guarantee of the directors' resolution;
Agreement to utilise the monies drawn in terms of contract should bear
the company's seal;
Letter of hypothecation for bills
b) Post shipment finance : It takes the below mentioned forms :

i) Purchase/Discounting of documentary export bills : Finance is provided to

exporters by purchasing export bills drawn payable at sight or by discounting
usuance export bills covering confirmed sales and backed by documents
inclusive of documents of title to goods such as bill of lading, post parcel
receipts or air consignment notes. Documents to be obtained are :
Letter of hypothecation covering the goods; and
General guarantee of directors or partners of the firm, as the case may
be.
E.C.G.C. Guarantee : Post-shipment finance, given to an exporter by bank
through purchase, negotiation or discount of an export bill against an order,
qualifies for post-shipment export credit guarantee. It is necessary, that
exporters obtain a shipment or contracts risk policy of E.C.G.C. Banks insist on
the exporters to take a contracts shipments (comprehensive risks) policy
covering both political and commercial risks. The Corporation, on acceptance of
the policy, would fix credit limits for individual exporters and the Corporation's
liability will be limited to the extent of the limit so fixed for the exporter
concerned irrespective of the policy amount.

ii) Advance against export bills sent for collection : Finance is provided by
banks to exporters by way of advance against export bills forwarded through
them for collection, taking into account the party's creditworthiness, nature of
goods exported, usuance, standing of drawee, etc. appropriate margin is kept.
Documents to be obtained :
Demand promissory note;
Letter of continuity;
Letter of hypothecation covering bills;
General guarantee of directors or partners of the firm, as the case may be.

iii) Advance against duty draw backs, cash subsidy, etc. : To finance export
losses sustained by exporters, bank advance against duty draw-back, cash
subsidy, etc. receivable by them against export performance. Such advances are
of clean nature, hence, necessary precaution is to be exercised.

Conditions : Bank providing finance in this manner should see that the relative
export bills are either negotiated or forwarded for collection through it so that, it
is in a position to verify the exporter's claims for duty draw-backs, cash subsidy,
etc. An advance so availed by an exporter is required to be liquidated within 180
days from the date of shipment of relative goods.

Documents to be obtained are :

Demand promissory note;
Letter of continuity;
General guarantee of directors or partners of the firm, as the case may
be.
Undertaking from the borrowers that they will deposit the
cheques/payments received from the appropriate authorities immediately
with the bank and will not utilise such amounts in any other way.
c) Other facilities extended to exporters :

i) On behalf of approved exporters, banks establish letters of credit on their

overseas or up-country suppliers.

ii) Guarantees for waiver of excise duty, etc. due performance of contracts, bond
in lieu of cash security deposit, guarantees for advance payments, etc. are also
issued by banks to approved clients.

iii) To approved clients undertaking exports on deferred payment terms, banks

also provide finance.

iv) Banks also endeavour to secure for their exporter-customers status reports of
their buyers and trade
information on various commodities through their correspondents.

v) Economic intelligence on various countries is also provided by banks to their

exporter clients.

5) Inter corporate deposits : The companies can borrow funds for a short
period say 6 months from other companies having surplus liquidity. The rate of
interest on it varies depending on the amount involved and time period.

6) Certificate of deposit (CD) : It is a document of title similar to a time deposit

receipt issued by a bank except, that there is no prescribed interest rate on such
funds. Its main advantage is that banker is not required to encash the deposit
before maturity period and the investor is assured of liquidity as he can sell it in
the secondary market.

7) Public deposits : They are important source of short and medium term
finances particularly due to credit squeeze by the RBI. A company can accept
such deposits subject to the stipulations of the RBI from time to time maximum
upto 35 % of its paid up capital and reserves, from the public and the
shareholders. These may be accepted for a period of 6 months to 3 years. Public
deposits are unsecured loans, and not meant to be used for acquisition of fixed
assets, since, they are to be repaid within a period of 3 years. These are mainly
used to finance working capital requirements.

Question : Enumerate and explain the other sources of financing ?

Answer : The other sources of financing are as discussed below :

1) Seed capital assistance : The seed capital assistance scheme is designed

by IDBI for professionally or technically qualified entrepreneurs and/or persons
possessing relevant experience, skills and entrepreneurial traits. All the projects
eligible for financial assistance from IDBI, directly or indirectly through refinance
are eligible under the scheme. The project cost should not exceed Rs. 2 crores
and the maximum assistance under the project will be restricted to 50 % of the
required promoter's contribution or Rs. 15 lakhs, whichever is lower. Seed
capital assistance is interest free, but carries a service charge of 1 % per annum
for the first 5 years and at increasing rate thereafter. However, IDBI will have the
option to charge interest at such rate as determined by it on the loan if the
financial position and profitability of the company so permits during the currency
of the loan. The repayment schedule is fixed depending on the repaying capacity
of the unit with an initial moratorium upto 5 years. For projects with cost
exceeding Rs. 200 lakhs, seed capital may be obtained from the Risk Capital and
Technology Corporation Ltd. (RCTC). For small projects costing upto Rs. 5 lakhs,
assistance under the National Equity Fund of the SIDBI may be availed.

2) Internal cash accruals : Existing profit making companies undertaking an

expansion/diversification programme may be permitted to invest a part of their
accumulated reserves or cash profits for creation of capital assets. In such
cases, the company's past performance permits capital expenditure from within
the company by way of disinvestment of working/invested funds. In other words,
the surplus generated from operations, after meeting all the contractual,
statutory and working requirement of funds, is available for further capital
expenditure.

3) Unsecured loans : They are provided by promoters to meet the promoters'

contribution norm. These loans are subordinate to institutional loans and interest
can be paid only after payment of institutional dues. These loans cannot be
repaid without the prior approval of financial institutions. Unsecured loans are
considered as part of the equity for the purpose of calculating debt equity ratio.

4) Deferred payment guarantee : Many a time suppliers of machinery provide a

deferred credit facility under which payment for the purchase of machinery may
be made over a period of time. The entire cost of machinery is financed and the
company is not required to contribute any amount initially towards acquisition of
machinery. Normally, the supplier of machinery would insist that the bank
guarantee be furnished by the buyer. Such a facility does not have a moratorium
period for repayment. Hence, it is advisable only for an existing profit making
company.

5) Capital Incentives : Backward area development incentives available often

determine the location of a new industrial unit. They usually consist of a
lumpsum subsidy and exemption from or deferment of sales tax and octroi duty.
The quantum of incentives is determined by the degree of backwardness of the
location. Special capital incentive in the form of a lumpsum subsidy is a quantum
sanctioned by the implementing agency as a percentage of the fixed capital
investment subject, to an overall ceiling. This amount forms a part of the long-
term means of finance for the project. However, the viability of the project must
not be dependent on the quantum and availability of incentives. Institutions,
while appraising the project, assess its viability per se, without considering the
impact of incentives on the cash flows and the project's profitability. Special
capital incentives are sanctioned and released to the units only after they have
complied with the requirements of the relevant scheme. The requirements may
be classified into initial effective steps, that include formation of the
firm/company, acquisition of land in the backward area and registration for
manufacture of the products. The final effective steps include obtaining
clearances under FEMA, capital goods clearance/import license, conversion of
Letter of Intent to Industrial License, tie up of the means of finance, all
clearances required for the setting up of the unit, aggregate expenditure incurred
for the project should exceed 25 % of the project cost and atleast 10 %, if the
fixed assets should have been created/acquired at site. The release of special
capital incentives by the concerned State Government generally takes 1 to 2
years. Promoters thus, find it convenient to avail the bridge finance against the
capital incentives. Provision for the same should be made in the pre-operative
expenses considered in the project cost. As the bridge finance may be available
to the extent of 85 %, the balance i.e. 15 % may have to be brought in by the
promoters from their own resources.

6) Various short term provisions/accruals account : Accruals accounts are a

spontaneous source of financing as they are self-generating. The most common
accrual accounts are wages and taxes. In both cases, the amount becomes due
but is not paid immediately.

Question : Write short notes on :

1) Deep Discount Bonds 2) Secured Premium
Notes
3) Zero interest fully convertible debentures 4) Zero Coupon Bonds
5) Double Option Bonds 6) Option Bonds
7) Inflation Bonds 8) Floating Rate Bonds

Answer :
1) Deep Discount Bonds :
It is a form of a zero interest bond, sold at a discounted value and on
maturity face value is paid to the investors. In such bonds, there is no interest
paid during lock in period. IDBI was the first to issue a deep discount bond in
India in January, 1992. It had a face value of Rs. 1lakh and was sold for Rs.
2700 with a maturity period of 25 years. The investor could hold the bond for 25
years or seek redemption at the end of every 5 years with maturity value as
below :

Holding period
5 10 15 20 25
(years)
Maturity value (Rs.) 5700 12000 25000 50000 100000
Annual rate of
16.12 16.09 15.99 15.71 15.54
interest (%)

The investor can sell the bonds in stock market and realise the
difference between face value (Rs. 2700) and the market price as capital gain.

2) Secured Premium Notes :

It is issued along with a detachable warrant and is redeemable after a
notified period of say 4 to 7 years. The conversion of detachable warrant into
equity shares will have to be done within the time period notified by the
company.

3) Zero interest fully convertible debentures :

These are fully convertible debentures which do not carry any interest.
They are compulsorily and automatically converted after a specified period of
time and holders thereof are entitled to new equity shares of the company at
predetermined price. From the company's view point, this kind of instrument is
beneficial in the sense, that no interest is to be paid on it, if the share price of
the company in the market is very high, then the investor tends to get equity
shares of the company at a lower rate.

4) Zero Coupon Bonds :

A zero coupon bond does not carry any interest, but it is sold by the
issuing company at a discount. The difference between the discounted and
maturing or face value represents the interest to be earned by the investor on
them.

5) Double Option Bonds :

Double Option Bonds are recently issued by the IDBI. The face value of
each bond is Rs. 5000, it carries interest at 15 % per annum compounded half
yearly from the date of allotment. The bond has a maturity period of 10 years.
Each having 2 parts, in the form of 2 separate certificates, one for the principal
of Rs. 5000 and other for interest, including redemption premium of Rs. 16500.
Both these certificates are listed on all major stock exchanges. The investor has
the facility of selling either one or both parts anytime he likes.

6) Option bonds :
 These are cumulative and non-cumulative bonds where interest is
payable on maturity or periodically. Redemption premium is also offered to
attract investors. These were recently issued by IDBI, ICICI, etc.

7) Inflation bonds :
They are bonds in which interest rate is adjusted for inflation. The
investor, thus, gets an interest free from the effects of inflation. For instance, if
interest rate is 12 % and inflation rate is 5 %, the investor will earn 17 %,
meaning that the investor is protected against inflation.

8) Floating Rate Bonds :

As the name suggests, Floating Rate Bonds are ones, where the rate of
interest is not fixed and is allowed to float depending upon the market
conditions. This is an ideal instrument that can be resorted to by the issuer to
hedge themselves against the volatility in interest rates. This has become more
popular as a money market instrument and has been successfully issued by
financial institutions like IDBI, ICICI, etc.

Question : Give a detailed account of International Financing ?

Answer : The essence of financial management is to raise & utilise the funds
raised effectively. There are various avenues for organisations to raise funds
either through internal or external sources. External sources include :
Commercial banks : Like domestic loans, commercial banks all over the
world extend Foreign Currency (FC) loans, for international operations.
These banks also provide to overdraw over and above the loan amount.
Development banks : offer long and medium term loans including FC
loans. Many agencies at the national level offer a number of concessions
to foreign companies to invest within their country and to finance exports
from their countries e.g. EXIM Bank of USA.
Discounting of trade bills :This is used as a short term financing method
widely, in Europe and Asian countries to finance both domestic and
international business.
International agencies : A number of international agencies have
emerged over the years to finance international trade and business. The
more notable among them includes : International Finance Corporation
(IFC), International Bank for Reconstruction & Development (IBRD), Asian
Development Bank (ADB), International Monetary Fund (IMF), etc.

International capital markets :

Modern organisations including MNC's depend upon sizeable
borrowings in Rupees as also Foreign Currency. In order to cater to the needs of
such organisation , international capital markets have sprung all over the globe
such as in London. In International capital market, the availability of FC is
assured under the 4 main systems, as :
Euro-currency market
Export credit facilities
Bonds issues
Financial Institutions
The origin of the Euro-currency market was with the dollar
denominated bank deposits & loans in Europe particularly, London. Euro-dollar
deposits are dollar denominated time deposits available at foreign branches of
US banks and at some foreign banks. Banks based in Europe accept & make
dollar denominated deposits to the clients. This forms the backbone of the Euro-
currency market all over the globe. In this market, funds are made available as
loans through syndicated Euro-credit of instruments as FRN's, FR certificates of
deposits.

Below mentioned are some of the financial instruments :

1) Euro Bonds : Euro Bonds are debt instruments denominated in a currency
issued outside the country of that currency, for instance : a yen note floated in
Germany.

2) Foreign Bonds : These are debt instruments denominated in a currency which

is foreign to the borrower and is sold in the country of that currency.

3) Fully Hedged Bonds : In foreign bonds, the risk of currency fluctuations

exists. They eliminate the risk by selling in forward markets the entire stream of
principal and interest payments.

4) Floating Rate Notes : They are issued upto 7 years maturity. Interest rates
are adjusted to reflect the prevailing exchange rates. They provide cheaper
money than foreign loans.

5) Euro Commercial Papers (ECP) : ECP's are short term money market
instruments, with maturity of less than 1 year and designated in US dollars.

6) Foreign Currency Option : A FC Option is the right to buy or sell, spot or

future or forward, a specified foreign currency. It provides a hedge against
financial and economic risks.

7) Foreign Currency Futures : FC Futures are obligations to buy or sell a

specified currency in the present for settlement at a future date.

8) Euro Issues : In the Indian context, Euro Issue denotes that the issue is
listed on a European Stock Exchange. However, subscription can come from any
part of the world except India. Finance can be raised by Global Depository
Receipts (GDR), Foreign Currency Convertible Bonds (FCCB) and pure debt
bonds. However, GDR's and FCCB's are more popular.

9) Global Depository Receipts : A depository receipt is basically a negotiable

certificate, denominated in US Dollars representing a non US company's publicly
traded local currency (Indian Rupee) equity shares,. Theoretically, though a
depository receipt can also signify debt instrument, practically it rarely does so.
DR's are created when the local currency shares of an Indian company are
delivered to the depository's local custodian bank, against which the depository
bank issues DR's in US Dollars. These DR's may be freely traded in the
overseas- markets like any other dollar denominated security via either a foreign
stock exchange or through a over the counter market or among a restricted
group as Qualified Institutional Buyers (QIB). Rule 144 A of the Securities and
Exchange Commission (SEC) of USA permits companies from outside USA to
offer their GDR's to certain institutional buyers, known as QIBs.

10) GDR with Warrant : These receipts are more attractive than plain GDR's in
view of additional value of attached warrants.

11) American Depository Receipts (ADR's) : Depository Receipts issued by a

company in USA is known as ADR's. Such receipts have to be issued in
accordance with the provisions stipulated by the SEC, USA that are stringent. In
a bid to bypass such stringent disclosure norms mandated by the SEC for equity
shares, the Indian companies have, however, chosen the indirect route to tap the
vast American financial market through private debt placement of GDR's listed in
London and Luxembourg stock exchanges.

Indian companies have preferred the GDR's and ADR's as the US

market exposes them to a higher level or responsibility than a European listing
in the areas of disclosure, costs, liabilities and timing. The SECs regulations set
up to protect the retail investor base are some what more stringent and onerous,
even for companies already listed and held by retail investors in their home
country. Most onerous aspect of a US listing for companies is to provide full, half
yearly and quarterly accounts in accordance with or atleast reconciled with US
GAAPs. However, Indian companies are shedding their reluctance to tap the US
markets as evidenced by Infosys Technologies Ltd. recent listing in NASDAQ.
Most of India's top notch companies in the pharmaceutical, info-tech and other
sunrise industries are planning forays into the US markets. Another prohibitive
aspect of the ADR's vis--vis GDR's is the cost involved of preparing and filling
US GAAP accounts. Additionally, the initial SEC registration fees based on a
percentage of issue size anmd 'Blue Sky' registration costs, permitting the
securities to be offered in all States of US, will have to be met. The US market is
widely recognised as the most litigious market in the world. Accordingly, the
broader the target investor base in US, higher is the potential legal liability. An
important aspect of GDR is that they are non voting and hence spells no dilution
of equity. GDRs are settled through CEDEL and Euro-clear International Book
Entry Systems.

Other types of International issues :

Foreign Euro Bonds : In domestic capital markets of various countries
the Bond issues referred to above are known by different names as
Yankee Bonds in US, Swiss Frances in Switzerland, Samurai Bonds in
Tokyo and Bulldogs in UK.
Euro Convertible Bonds : A convertible bond is a debt instrument giving
the holders of the bond an option to convert the bonds into a pre-
determined number of equity shares of the company. Usually, the price of
equity shares at the time of conversion will have a premium element. They
carry a fixed rate of interest and if the issuer company so desires may
also include a Call Option, where the issuer company has the option of
calling/buying the bonds for redemption prior to the maturity date, or a
Put Option, which gives the holder the option to put/sell his bonds to the
issuer company at a pre-determined date and price.
Euro Bonds : Plain Euro Bonds are nothing but debt instruments. These
are not very attractive for an investor who desires to have valuable
additions to his investments.
Euro Convertible Zero Bonds : These are structured as a convertible
bond. No interest is payable on the bonds. But conversion of bonds take
place on maturity at a pre-determined price. Usually, there is a 5 years
maturity period and they are treated as a deferred equity issue.
Euro Bonds with Equity Warrants : These carry a coupon rate
determined by market rates. The warrants are detachable. Pure bonds are
traded at a discount. Fixed Income Funds Management may like to invest
for the purposes of regular income.